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The necessity of strategy

 

By Randy Neumann

No matter what investors do with their money, there are risks involved that can derail their financial goals. If they invest, they can suffer losses. If they don’t, inflation can erode the value of their savings. For investors to reach their goals, all of these risks need to be anticipated and managed through a solid financial plan.

Building such a plan – one that can endure over the years – doesn’t happen by accident. Investors need a solid understanding of every investment in their portfolio, and the risks they carry. They need a strategy that prepares them for a variety of economic environments.

I recently attended a seminar titled “Rethinking Risk,” presented by Invesco, one of the largest money management firms in the world. The presentation, which had some interesting insights into investing, began with five myths offset by five truths followed by five actions.

Here they are.

Myth 1

Myth: “My portfolio will be in fine shape if it has more up years than down years.”

Truth: The magnitude of gains and losses counts more than their frequency. Action: Understand the market scoring system and design an investment strategy accordingly.

Myth 2

Myth: “Missing the market’s best days is the worst thing I could do to my portfolio.”

Truth: The market’s worst days are just as important as its best days (and maybe even more). Action: Remain invested, but seek to avoid catastrophic losses.

Myth 3

Myth: “Market returns are the key to my portfolio’s value.”

Truth: Contributions form the foundation of a portfolio’s value. Action: Maximize contributions, and build goals based on realistic savings assumptions.

Myth 4

Myth: “If there’s no sign of recession (or recovery) on the horizon, I don’t need to prepare for one.”

Truth: Prudential risk management means always being prepared. Action: Be prepared for the unexpected.

Myth 5

Myth: “I’m diversified – my portfolio has lots of different stocks.”

Truth: True diversification is based on sources of risks, not returns. Action: Diversify investment portfolios by sources of risks, not returns.

Let’s begin by separating the myth from the truth in number 1. It’s true that from 1926 to 2010, the S&P 500 Index has posted 61 positive years and only 24 negative years. That would be good news for an investment portfolio – if it were scored by “match play” rules, like tennis. In that scenario, investors would be winners, if the up years outnumber the down years. How well they performed in each of those years wouldn’t matter.

However, in reality, portfolios are scored under “stroke play” rules – like golf. In stroke play, it doesn’t matter how many individual holes you win, it’s the total score that counts. Mistakes on just one hole or two can ruin an otherwise well-played game. Likewise, in investing, it may take just one or two exceptionally bad years to push an investor off the path to victory.

As we saw during the 2000s, it’s possible for the market to have more up years than down years, yet still lose money on average.

Last Decade’s Scorecard: Winner or Loser

The tennis player would consider this a victory. The golfer – and the investor – would not.

Average annual returns of the S&P 500 index (in percentages): 2000, -9.10; 2001, -11.88, 2002, -22.09; 2003, 28.67; 2004, 10.87; 2005, 4.91; 2006, 15.78; 2007, 5.49; 2008, -36.99; 2009, 26.47.

The total return for the decade (cumulative) was -9.10 percent, with 6 up years and 4 down years. (Source: Lipper Inc. The S & P 500 index is an unmanaged index considered representative of the US stock market. An investment cannot be made directly in an index. Past performance is no guarantee of comparable future results.)

Now that we know the market keeps score, an important question remains: In investing, how is victory achieved?

Many investors believe if their portfolio makes money during their investment lifetime, they’ve achieved victory. Once again, we’re mixing myth and reality.

Investment results are one thing; financial goals are another. You have only achieved victory when your investment portfolio generates enough income to provide you with a comfortable retirement, and, if it is your goal, to provide a nest egg for the next generation.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for the individual. Randy Neumann, CFP® is a registered representative with and securities and insurance offered through LPL Financial. Member FINRA/SIPC. He can be reached at 600 East Crescent Avenue, Suite 104, Upper Saddle River, NJ 07458, 201-291-9000.

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