I had an interesting conversation about retirement planning yesterday with a former colleague of mine. She needed help setting up her 401k as she is now taking her retirement seriously. Now, as an aspiring economist it has been a few years since I have done this type of work so I had forgotten the issues with this process. But she made a few remarks that were a stark reminder to me that planning for retirement is not easy.
1) “This is so overwhelming!”
She was referring to the sheer number of investment choices and how to research them all (she is one of those “research” everything type of people). This is common for individuals who are looking at their 401ks. All they see is a long list of names and deciding on which options can be difficult. I can relate to this when I go shopping. I have been known to stand in a store looking at the same clothes for 30-45 minutes weighing the pros and cons of each item. But, when it comes to investing, I have never had this problem.
The best way to get around the “overwhelming” problem is to remember that mutual funds are managed by professionals. Are they always right? Of course not. This is why passive and index funds have become popular. But while the active managers may not hit home runs everyday, they will do a good enough job to get you on your way.
My former colleague is lucky I was able to share my system with her to make choosing investment much less overwhelming. But in general, don’t let the fancy names and numbers overwhelm you.
2) “How do I know which ones will be the best?”
Well, first off, you don’t know. Nobody can predict the future. I always tell people, if you ever meet a financial professional who says they know what’s going to happen in the future, please run away. Maybe even call the Police and the FBI. Or better yet, maybe we will need Wonder Woman, Thor, and the Hulk. They can surely deal with someone who can predict the future.
In all seriousness, this might be the biggest hurdle for most people. As humans we want to pick what we perceive to be the best. And in terms of investments, the best will almost always be whichever provides the best returns. More sophisticated investors will look at risk adjusted returns. But, since we do not know what the future holds, my advice has always been choose a fund and manager that has the same world view as you.
For instance, if you believe the global economy and currencies will collapse, you might be best suited to invest in managers that are heavy in gold. If you believe rates will keep rising, selecting managers that are overweight financials and bank stocks is the way to go.
And related to this…
3) “Can’t I just look at past returns and pick the best?”
Well, while this makes sense, past performance is never an indicator of future performance. And this is not merely a disclosure the SEC and FINRA forces firms to slap on their marketing material, it is in fact true.
A manager might have the #1 fund every year for 10 years, and the 11th year this manager might be the worst. You just don’t know. This is why looking at the holdings and manager’s world view are critical. If you find a manager who sees the world outlook the same way you do, then you will rest easy. That is, unless your world view is out of touch with reality… Then your portfolio will suffer.
4) “Can’t I just pick the index funds?”
Absolutely! While I am still a proponent of active management as I personally do very well, the fact is index funds take the picking and choosing out of the equation. And they can provide returns almost equivalent to the actual index.
5) “Is that even good?”
Well, it depends on your definition of good relative to the risk. In this instance the active equity mutual funds have returned over 20% the last 12 months compared to the S&P 500 Index fund at around 10%. Granted the equity funds have the ability to invest internationally – which is the place to be at the moment. That said, international stocks are significantly more risky; especially with the possibility of tariffs from this administration and ongoing corruption in EM.
So, while 10% may not seem great, it is good relative to the risk. This is why more sophisticated investors look at risk adjusted returns because it tells you how much return you get per unit of risk.