Chapter 6
You Must Invest to Meet Your Goal
The previous chapter's exercise for specifically identifying your financial goal is vital to the planning process, because if you don't have a clear vision of what you're attempting to accomplish, you'll find that it is nearly impossible to craft an appropriate approach for getting where you want to go. However, as you just learned, specifically targeting your financial destination really isn't that hard to do. Better still, once you've identified and clarified your financial goal, the next step logically falls into place.
Basically, after you determine how much money you need to accumulate and distribute, you'll need to build a portfolio to accomplish your goals. Building that portfolio can be as simple or as complicated as people want to make it. The approach that follows does have a dash of science behind it, but the real focus is on making it as logical as possible.
Remember, once you build out your portfolio, you're immediately going to walk into a financial haunted house. Financial boogeymen and other nasties are constantly going to jump out and surprise you, trying to get you to abandon your carefully constructed plan. The media and the public at large aren't evil, and they aren't out to ruin your finances. But even when they have the best of intentions, the end result of the mayhem around you will be to make it extremely difficult for you to stay the course.
That's where the logic comes in. Having a portfolio that makes sense can help you hold on when times get tough and your emotions threaten to get the best of you.
With that in mind, it's time to go deeper and explore the process of building and implementing your investment portfolio.
How Much Money Do You Want to Make?
Question: How much money do you want to make?
Answer: As much as possible!
If I were to ask 100 people how much money they want to make from their investments, I'm pretty sure most would respond with the same answer. But is that actually the right answer?
I'd like to suggest that you do not actually want to make as much money as possible from your investments.
I know. I know. I'm a blasphemer, and you're probably about to burn me in effigy right now. But bear with me a little longer.
Of course, on the surface it's obvious that you'd want to make as much money as possible. Who wouldn't? But let's dig deeper on this.
What if I gave you two choices? The first choice is an investment that should make you 15% returns over time. The second investment should make you 5% returns. Naturally, you prefer the 15% returns, particularly if your neighbor and your co-workers are all getting 15%. Because it would feel dreadful to know that you aren't doing as well as all your friends. You must, of course, keep up with the Joneses in all things.
But what if I also told you that the first investment is going to experience nausea-inducing ups and downs and that there will be times when you're spending your retirement worried about whether you'll have to go back to work because you lost all your money? Would that first investment still sound like a good idea?
Imagine, too, that in the scenario just described you don't actually need to make 15% in order to maintain your retirement lifestyle. Sure, it would be nice to see your portfolio balloon in value. But it's not necessary for it to do so. And therefore, those sleepless nights of financial uncertainty are also unnecessary.
Would you still want that 15% investment?
How Much Money Do You Need to Make?
There is a logical progression in the steps you must take to achieve financial independence. For instance, you must first identify and clarify your financial goal and determine how much money you need to meet that goal. That information in turn will guide you to one of the most important figures in determining your financial future: your required rate of return.
A required rate of return is simply the minimum return on your investments that you must achieve in order to meet your financial goal. In other words, it tells you how much money you need to make.
At the most basic level, there are two types of risk you face when investing. The first is known as shortfall risk. Shortfall risk is simply the risk that you don't generate sufficient returns to meet your financial goal. In other words, this is the risk that you run out of money. I'd strongly argue that shortfall risk is the greatest danger you face, because ultimately the measure of any journey's success is whether you reached your destination.
In order to avoid shortfall risk, you must generate returns equal to or greater than your required rate of return. If you do this, you'll meet your goal. If you fail to do this, you'll fall short of your goal. It's as simple as that.
Your returns need to meet your required rate of return. In other words, that required rate of return tells you how much money you need to make.
How Much Risk Should You Take?
If you've been investing for a while, you probably remember at least a couple of the events shown in Figure 6.1. And how about the market turmoil prompted by the COVID-19 pandemic? What were you feeling while major stock market indexes plunged more than 30% in the course of a month?
| Black Monday in October 1987, when the Dow fell 22% in a single day |
| The Dot-com Meltdown and Bear Market of the early 2000s |
| The Financial Crisis of 2007–2009 |
| The “Flash Crash” of 2010 when the Dow fell and rose 1,000 points in 15 minutes |
| December 2018, when stocks dropped approximately 20% |
Figure 6.1 Major Market Events of the Last Three Decades
SOURCE: Analysis by Brian Perry.
Here's a silly question: Did you have fun investing during any of those periods? Probably not, unless you happened to have a large chunk of money you were waiting to put to work and were able to buy stocks when they were on sale.
As you get closer to, and eventually transition into, retirement, market volatility becomes even less “fun.” Let's face it; from a financial perspective, retirement requires a pretty significant mindset shift. After all, you've spent decades working to accumulate money. Your goal has always been (at least from a financial perspective) to have as much money as possible.
And then, when you retire, you realize that you might never again contribute to your accounts. In fact, rather than continuing to grow your pile of money, you'll now begin spending down your accumulated savings. Instead of growing, your financial resources may start to shrink.
Now couple this scenario with a situation in which market volatility is causing a sharp drop in your portfolio. Not only do you have to spend down the money you worked so hard to accumulate, you also have to lock in losses by selling into a declining market. And you're likely seeing your savings decline (through a combination of withdrawals and market declines) at a rate beyond what you're comfortable with.
There is a simple solution to this. It's not perfect, because you'll likely still see some of your savings periodically subjected to steep market selloffs. Nevertheless, once you determine your required rate of return, determining how much risk to take is actually quite simple. Basically, you want to take as little risk as possible in achieving your required returns. After all, no one ever got on an airplane and rooted for turbulence. So why would you want to experience a ride that is bumpier than necessary in your investment portfolio?
Remember, first you determine your required rate of return. Then you need to identify portfolios likely to meet that required rate over time. Doing so will help you to manage shortfall risk. Once you've done this, the next step is choosing which of the available portfolios you want to invest in. In general, your choice should then be the portfolio with the least risk.
It is important to realize that choosing the portfolio with the least amount of risk will likely result in lower returns than if you chose a more aggressive portfolio. You may not keep pace with the S&P 500, or with your brother-in-law or co-workers. As with many things in life, there are trade-offs here. Basically, you are sacrificing potentially higher returns for a higher degree of certainty that you won't run out of money. You are also choosing fewer sleepless nights.
Let's take a closer look at Figure 6.2 in order to get a better sense of some of the trade-offs you'll have to consider. Remember, the first thing you need to accomplish when investing is to achieve a rate of return sufficient to meet your financial goal. This number is your required rate of return, and meeting that requirement is not optional. With that in mind, if you've done your financial planning and determined that your required rate of return is 4%, you can choose from any of the portfolios shown in Figure 6.2.
| Expected Annual Return | Standard Deviation | Maximum Drawdown | |
| Portfolio 1 | 4% | 7% | 12% |
| Portfolio 2 | 6% | 12% | 20% |
| Portfolio 3 | 8% | 20% | 30% |
Figure 6.2 Sample Portfolio Risk and Return
SOURCE: Analysis by Brian Perry.
But what if your required rate of return is higher? What if it's 6%? Well, in that case, you can no longer choose Portfolio 1, because that portfolio is unlikely to generate sufficient returns for you to meet your financial goal. In other words, because your required rate of return is 6%, and the expected return of Portfolio 1 is only 4%, you must eliminate that portfolio from consideration because you must achieve your required rate of return over time. And if I sound like a broken record on that point, it is only because it is so important to achieving the future you desire and deserve.
Okay, so you need at least 6% from your portfolio, and you've therefore eliminated Portfolio 1 from consideration. Which portfolio, from among the two remaining, should you then choose? Portfolio 3 certainly sounds good. After all, who wouldn't want to get 8% a year from their investments? And more is always better than less, isn't it?
I'll grant you that more is better than less, as long as everything else is equal. But look again at the chart, because in this case everything else is most certainly not equal. Yes, Portfolio 3 is expected to generate significantly higher returns than Portfolio 2. But it also carries more risk.
The standard deviation of Portfolio 3 is 20%, whereas the standard deviation of Portfolio 2 is only 12%. That means that you can expect Portfolio 3 to bounce around a lot more than Portfolio 2. Furthermore, the maximum drawdown of Portfolio 3 is 30%, as compared to only 20% for Portfolio 2.
Maximum drawdown measures how large of a decline the portfolio is expected to suffer in a worst-case scenario. In other words, at some point you can expect Portfolio 2 to drop by 20%. And at some point you can expect Portfolio 3 to plummet by 30%. If you are like most folks, a 30% decline is likely to be a far more painful experience than a 20% fall, especially when you are retired and unable to add any more money to your investment portfolio.
So, although Portfolio 3 offers higher expected returns, which are nice, the correct choice of a portfolio might be Portfolio 2. That investment mix generates sufficient returns to meet your financial goals, but is also safer and will cause less financial stress and fewer sleepless nights.
Choosing the portfolio with the least risk is a general rule of thumb, and of course there are exceptions to this. For example, if your situation is such that you are unlikely to run out of money, and you have a legacy goal of leaving money to family or charity, you may choose to take on more risk than necessary in order to generate higher returns over time. After all, in that situation you aren't only investing for yourself, but also for your family or favorite charity, either of which might have a much longer time horizon than you do.
The type of risk I am focusing on now is generally referred to as volatility. This is the risk you are probably most familiar with as an investor. It is also the type of risk you see highlighted any time a news headline screams about a stock market decline.
Volatility can be unnerving, and it has caused many investors to panic and abandon their portfolios at inopportune times. That is why you want to minimize the volatility within your portfolio.
Remember, however, and this is one of the most important points in this book, you only want to minimize the volatility of your portfolio from among the choices that will still get you to your financial goal. In other words, volatility hurts. But shortfall risk is what will kill your financial dreams.
Sleeping on a Bed of Money
Okay, so you want to build a portfolio that will generate the returns you need with the least amount of risk. But how do you go about doing that? Well, there are a number of different ways to build such a portfolio, but let's take a look at an approach that makes a lot of sense. This approach is based on the simple, fundamental concept that the less time you spend worrying about market volatility, the happier you're likely to be.
Remember how earlier in the book you learned that certain securities have higher expected returns than others. Well, hopefully, you intuitively grasp the idea that you want to own more of the securities with superior risk-and-return characteristics. Now let's put together a hypothetical example of how selecting those investments can help you build a portfolio that will get you the returns you need while still allowing you to sleep at night.
Let's consider a scenario in which you have only two investment options. Option one is that you can buy stocks, and option two is that you can stick your money under the mattress.
When you stick your money under the mattress, you know that it isn't going anywhere. Your money isn't going to disappear in a market crash. You don't have to worry about what the economy is doing or who wins the next election. You know exactly where your money is at all times, with the result that you sleep better at night.
What's the bad news though? Well, that's obvious. The bad news is that your money won't grow in value when it's under the mattress. Therefore, if all of your money goes under the mattress, you won't generate the returns necessary to meet your financial goal. In fact, you might actually be losing money as inflation eats away at your purchasing power.
With that in mind, you can't simply put all of your money under the mattress. Doing so would cause you to fall short of your financial goal. But on the other hand, it sure is nice knowing you have that money under the mattress. And I'll bet you sleep better knowing that you're lying down on a bed of money. Therefore, the idea is to have as much money under the mattress as possible, while still meeting your financial goal.
Adding Some Stocks to the Mix
So, the goal is to have as much money as possible under your mattress. The more money you're sleeping on, the better you'll sleep. But the problem is that if all of your money goes under the mattress, you won't generate the returns needed to meet your financial goal. That's where stocks come into play.
The stocks you are going to buy are going to boost your overall returns, hopefully enough so that you meet your goal. Remember, the first step in building your portfolio involves calculating your required rate of return, which is done by projecting out your future income and expenses. Rule number one of building your portfolio is that you must achieve this required rate of return over time. Failure to do so means failure to meet your financial goals. The required rate of return is unique to each person's situation and goal, but for this example let's assume you need 6% from your portfolio.
Please note that there is no magic to the 6% number here; so don't assume that your portfolio has to generate that return. You might need more or less. I'm only choosing 6% for ease of math. In fact, all numbers in this section are designed to make the math clean, so please focus on the concepts and not the numbers.
In attempting to achieve that 6% return that you need to generate over time, you'll put some money under your mattress and some money into stocks. In order to sleep well at night, you want to put as much money as possible under your mattress, but keep in mind that the portion that goes under the mattress will not grow at all. The portion that goes into stocks will generate different returns depending on what stocks you buy.
For our simple example, you have two choices of stocks to buy.
- If you buy Stock A, you expect to get 8% returns over time.
- If you buy Stock B, you expect to get 10% returns over time.
We've previously established that more is better than less, so obviously 10% returns sound better than 8% returns. But which of these stocks is riskier? Maybe Stock A represents larger, more established companies. Maybe Stock B represents the stocks of smaller, less established companies.
So again, that important question: Which of these stocks is riskier? The correct answer is Choice B, every time. You never get something for nothing in the financial markets, and if an investment promises higher returns, it generally does so because it carries commensurately higher risk. Importantly, the kind of risk I am talking about here is volatility risk, or the threat that your investments will bounce up and down more violently.
However, our story doesn't end there. Yes, Choice B carries more risk than Choice A. But let's look at what happens when we put these investments together with some money under the mattress.
Portfolio A
Let's assume for the moment that you've decided that you're going to put your stock money in Choice A, which you expect to generate 8% returns over time. The remainder of your money will go under the mattress where it will be nice and safe. But unfortunately, your mattress money won't be growing while it is staying nice and safe.
Remember, and this is crucial, for this example you need to build your portfolio so that you expect to generate 6% returns over time in order to meet your financial goals. Also remember that 6% represents your required rate of return, and achieving this is not optional. It is called your required rate of return for a reason.
So here's the important question: If the remainder is going under the mattress and earning zero, what percentage of your wealth needs to go into Choice A?
Well, you need 6% from the whole portfolio, and the portion that goes under the mattress won't generate any returns, so you need to do some third-grade math, as follows:
So, if you go with Choice A, 75% of your money goes into stocks, and the remainder, or 25%, goes under the mattress.
Importantly, you expect that this portfolio will achieve the returns you need over time.
Portfolio B
Let's run through that same exercise, except using Choice B. Remember, these are the stocks with the higher expected returns, but in the financial markets you seldom get something for nothing. With greater return potential comes greater risk, and Choice B is more volatile and will fluctuate more in value.
You still need 6% returns from the overall portfolio, and the money under your mattress still earns nothing. But now, you expect 10% from your stocks. Using the same math as we used for Choice A, we find:
So, if you go with Choice B, 60% of your money goes into the stocks, and the remainder, or 40%, goes under the mattress. As with Choice A, this option is also expected to generate the returns you need in order to meet your financial goals.
But remember, while you need to meet your required rate of return, you also want to enjoy as smooth of a ride as possible. The stocks in Choice B are more volatile and will fluctuate more in value than those in Choice A.
Does this mean that Choice B is a poor one?
Not necessarily.
What Portfolio Do You Want?
Both of these portfolios are expected to return 6% over time, thereby getting you to your goal. This is the first, and most important, consideration when building your investment portfolio.
And as stated earlier, Stock Choice B is riskier than Stock Choice A. There is no getting away from that. You don't get more return without more risk.
But here is the absolutely vital point. Even though its stocks are more volatile, I might still prefer to have the B portfolio!
Think about it this way. Although the stocks in B are riskier, they also have higher expected returns. Because of that, you're able to hold fewer stocks in your mix while still attaining the rate of return you require. Holding fewer stocks allows you to hold commensurately more of your money under the mattress.
Portfolio B has fully 40% under the mattress, allowing you to sleep more comfortably at night. And, once you make sure your portfolio will allow you to meet your goal, the second thing you want to do is minimize your risk. Or, to put it in more human terms:
- Retirement Rule #1 = Don't run out of money
- Retirement Rule #2 = Enjoy your retirement (by not worrying about money)
The way you obey these two rules is by building a portfolio with an expected return that matches or exceeds your required rate, and by then taking on the least possible risk in order to get that return.
The important takeaway here is that risk shouldn't just be measured on an investment-by-investment basis. The risk that really matters is at the portfolio level. Your goal then is to put together a collection of investments, some of which may be risky on their own, into a portfolio that meets your financial goal with the least risk possible. That, in a nutshell, is the art of portfolio construction.
- Note: You shouldn't literally keep your money under the mattress of course, because doing so will prevent you from even keeping pace with inflation, let alone seeing your money grow. In the financial markets, high-quality bonds are the equivalent of money under the mattress. Those are the kinds of bonds discussed in Chapter 4, and they will serve as the money under your mattress as you build out your portfolio.
Still Not Convinced?
Here's another way of thinking about why you want more of your money under the proverbial mattress. Remember earlier in the book when we ran through your calculations for determining how much money you need to retire?
Well, just for this example lets pretend that you want to spend $100,000 per year in retirement and that you'll have $60,000 a year coming in from various fixed income sources. So you need $40,000 each and every year from your portfolio. Let's further assume that you've accumulated $1,000,000 for retirement.
Now let's reconsider the portfolios we built. Remember, portfolio B has 60% in stocks and 40% under the mattress. With a $1,000,000 portfolio that means you would have:
- $600,000 in stocks
- $400,000 under the mattress
For this example, you need to draw $40,000 per year from your portfolio. If you divide 400,000 by 40,000 you get:
Remember, you have $400,000 under your mattress and you need to draw $40,000 annually from your portfolio. So, what does the number 10 represent?
Ten is the number of years of living expenses you have sitting under the mattress before you have to use any of the money sitting in stocks.
In other words, in this example, you have an entire decade's worth of spending sitting under your mattress before you ever have to worry about what your stock portfolio is doing.
That is why you want to construct a portfolio with as many safe assets as possible. Doing so frees you from having to worry about the gyrations of the stock market, or the constant barrage of economic, political, and market headlines.
Let me ask you, how would you like to be able to have the following exchanges in retirement?
- Your friend: Are you worried the stock market's down 15%?
- You: Nope, ask me again in a decade.
- Your co-worker: Does the upcoming election make you nervous about your portfolio?
- You: Nope, I don't need to worry about my portfolio for the next ten years.
- Your cousin: They say there's a recession ahead. Are you worried about your investments?
- You: Nope, not unless the recession lasts for a dozen years.
Obviously, knowing that you have several years or more of spending locked into relatively safe investments can reduce the stress you feel when the more growth-oriented segment of your portfolio fluctuates.
The truth is that at the end of the day, there are a number of ways to manage risk in a diversified investment portfolio and the method I've laid out is only one of them. But it is effective, primarily because it focuses on the emotional aspects of retirement investing. This peace of mind then makes it easier to ignore the mayhem around you and stay on track toward your goals.
Enjoy Your Retirement!
You've worked hard, and you want to enjoy your retirement. And let's face it; it's never fun losing money. Bear markets are always frightening. This fear gets exacerbated when you enter retirement. At least when working you can tell yourself that if your portfolio falls too much you can always postpone your retirement and give your investments time to recover while you continue to contribute to your accounts.
But in retirement that's no longer the case. The amount you've saved is your nest egg, and there aren't going to be any more inflows to top it off (assuming you don't go back to work). As such, it's natural for retirees to worry about their portfolio when markets are falling.
The problem is that life is short, and retirement should be enjoyable. The last thing you want is to be using the mediocre Wi-Fi on your cruise ship to check your stock portfolio when you could be having fun at the pool bar. Similarly, financial worries can cause you to squander time spent with children, grandchildren, or treasured friends.
The combination of determining your required rate of return and then using financial research to determine where to focus your investments can then allow you to own as many safe assets as possible. In turn, having money socked away in safe investments can improve the quality of your retirement. The peace of mind factor is key here, and the idea that you have years or even decades of spending sitting in relatively stable assets can free you from financial worry, allowing you to get on with the important business of maximizing your retirement fun!