Last week I reported on the three top questions investors wanted answered when advisors recommended investments. The rankings came from a survey of investors, funded by Dimensional Fund Advisors, conducted in March 2014 by Advisor Impact. I suggested the top two of those factors, the risk associated with the investment and the expected future performance, probably didn’t belong at the top of the list. The third one, fees and costs, is certainly important, but under half of the respondents thought so.
This week we will focus on the three least important things investors wanted to know. All three deserved to be much higher on the list. In my experience, they are what most investors really need to know.
These three factors are:
• What are the chances the investment will lose money? Only 10% of investors thought it was important to ask about factors that contributed to historic performance. Just one-third thought it important to even ask about historical performance in general.
• What type of volatility can they expect? Only 17% of investors considered this important.
• How and why did the advisor select the investment for their portfolio? Only 21% of survey respondents thought this was important, and just 8% asked about the investment managers chosen.
1. Chances of losing money. This factor could be better addressed by asking about the specific factors that influenced historic performance of the security over various long-term economic climates. True, looking at the past performance of an investment is never a guarantee of future performance. Yet, if the historical periods evaluated contain a variety of economic conditions (high inflation, various economic cycles, various political influences, etc.) and long-term holding periods (at least 10 years or more), looking backward may give you a reasonable idea of what future performance might look like.
2. Volatility. Most investors will cognitively agree they fully understand that most investments that carry any chance of real (after inflation) significant long-term return will fluctuate. I say “cognitively” because, once that fluctuation happens on the downside, all cognitive understanding sometimes goes out the window and the emotional brain takes control.
One way of internalizing the potential fluctuation of an investment is to ask about its volatility. Specifically, its standard deviation. This measure of the amount of variation from the average is something an advisor can easily find out for almost every bond, stock, and mutual fund. Take the standard deviation times three, then subtract that number from the average return. This is the amount of value over one year your investment could drop (or rise) in 99% of all years. Stated conversely, there is only a 1% chance your investment would drop further in any one year.
3. Portfolio fit. I recently sent back a shirt that hung on me like a tent. While it would have been perfect for a larger guy, it was not a fit for me. Investments are similar. While some are perfect matches for one portfolio, they can be lethal in another. An over-allocation to emerging market stocks may make perfect sense for a newborn, but it could be a retirement disaster for a 90-year-old.
It’s important to ask why an investment belongs in your portfolio. You want investments (asset classes) that complement one another by tending to fluctuate independently of each other. In an ideal balance of investments, when some decrease in value the other half increase an equal or greater amount, and all of them earn a real return over time.
Some of these factors may seem difficult to understand, but they do matter. Give your advisor a chance to explain them; it can help you become a more informed investor.
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