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The "Financial Planning Blueprint" Blog

  • Writer's pictureJason Flurry, CFP

How to protect yourself from the silent killer in your investment portfolio

One of the most misunderstood things that I see when I’m reviewing someone’s financial situation is the amount of risk they think they’re taking in their investment portfolio compared to what they’re actually taking.

We’ve all been taught not to put all of our eggs in the same basket. That’s called diversification and it’s important. Too much of any one thing can leave you exposed to high levels of risk, even when that one thing is a good thing that may be going up in value. I’ve been managing money long enough to remember the days of WorldCom and Enron. They took a lot of good people down with them and ruined their lives in the process. It was a shame. And since then, of course, there have been many others who have gone way up and come way back down too in spite of what everybody thought about how rosy their futures were.

So putting your eggs in different baskets just makes sense. But, it’s only part of what’s actually needed to make your investments grow on a more consistent basis.

What people really need to focus on is the allocation they have in their investment mix. Let me say it this way. If you have diversified your savings by having your nest eggs in different baskets, that’s good. But, let’s say that because you lacked true allocation within your investments, you found out later that all of your eggs in all of those baskets were on the same truck - and the truck ended up in the ditch! You’d be very surprised at how big your losses could be. I don’t want that to happen to you.

Avoiding the silent killer In medicine, they say that high blood pressure is the silent killer because it can lead to so many other health problems, including death, without easily being detected through other symptoms in advance. The silent killer in investment portfolios is poor allocation and poor execution of a good allocation strategy. Without an awareness to help make sure both aspects are being managed properly, your wealth building strategy could be severely compromised and your long-term financial security could be ruined forever.

In this article I’m going to help you understand how to prevent this from happening to you by describing a couple of examples that I’ve seen recently. Here’s the first one.

Talent AND good luck I’ve been fortunate over the years to work with a number of people who have done a great job saving and investing. I met with one recently who has saved a couple of million dollars and diversified his holdings to include stocks, bonds, mutual funds, exchange traded funds, real estate, and even some privately held investment options that are usually only reserved for the most sophisticated types of investors. As I reviewed his portfolio and discussed his strategy with him, I found that he had designed most of his approach by himself. His philosophy was to own enough of something that it could make a difference if the upside panned out as he had hoped it would, but also to not known too much of anything just in case it didn’t. Not a bad strategy, wouldn’t you say?

As I looked at everything with some of the financial tools we use for our private clients, I noticed that he had allocated approximately 80% of his money in the market. This was not an intentional move on his part. It just ended up being that way. But, as I was reviewing the key factors that made his portfolio work over time, I observed this part of his allocation along with how much he had in large-company stocks versus smaller company stocks and whether his focus was on growth companies or more on value-oriented companies that usually also pay a dividend. Again, for an amateur, his allocation was remarkably strong and his performance had been very good.

So if everything looks so good, what was the problem?

Normally when you’re allocating a certain percentage to be in the market versus out of the market, one of the reasons you do that is to control your level of risk exposure. With only 80% “in the market,” I expected to see his overall risk level also be at roughly 80% of the market’s risk too, but it wasn’t. Because of how he had inadvertently allocated the “in the market” portion of his investments, his actual risk level compared to the market was 113%. He was very surprised when I showed him that because he didn’t realize he was being that aggressive.

Let me stop here to say that there’s nothing wrong with taking more risk than the market as long as you’re getting compensated for taking that risk by also earning above average returns. What I found in his case was that, while his returns were good, they were not 113% better than the market average. That means that he’s basically taking more risk and getting less return, which is not the way things are supposed to be structured.

Ideally, you would take as little risk as possible and get as much return as possible instead. So, in his situation, when we looked deeper at how the pieces were put together in his investment portfolio, I found that by adjusting the recipe a bit we could reduce his level of risk significantly and still capture most of the returns he had been used to getting. That was one positive improvement he could benefit from.

But let me ask you this question… Just because you can earn a higher rate of return, should you automatically take a higher level of risk to get it? The answer there is usually no.

In this particular gentleman’s situation, he didn’t need to earn 10% - 12% a year to meet his financial goals. Nor did he need to take that level of risk, even after we reduced it to a much lower level. In his situation, the biggest risk he faced was losing what he had, not missing out on the next great run in a strong bull market. Plus, since at this stage of the game the next 30% moves in the market averages are likely to be lower rather than higher, leaving that much risk on the table just didn’t make any sense for him.

After all, when you think about the market losing 30%, that may not sound too bad by itself. When that 30% translates to $725,000+ lost in your portfolio, that’s a totally different situation! And, when these kinds of market declines usually come about, the majority of the drop can happen quickly, going from top to bottom in just 6 - 18 months. So, when that happens, it feels like you’ve lost a fortune in a flash. And when this has happened in the past, the markets have taken between 4 - 6 years to recover, which seems like forever!

Seeing the light In this guy’s situation, he didn’t want to lose what he had worked so hard to accumulate and he didn’t want to potentially put his financial goals on hold for four or five years when it wasn’t necessary for him to have so much risk on the table. I showed him how to cut his risk levels down closer to 60% of what the market’s normal risk is, yet still leave the upside open to capture about 80% of the markets returns. Now, with the proper type of allocation in place and the correct implementation of that allocated strategy handled properly, his financial health improved dramatically.

Keep in mind that even after the changes we made he understands that if the market drops, and it will from time to time, that he will still lose some money. But this rebalanced, allocated portfolio will withstand the financial storms better allowing him to have fewer losses and quicker recoveries over time. That will keep his financial progress moving forward and give him much more peace of mind as he approaches life’s most important milestones with the ones he cares about the most.

Listen to your doctor So in the first situation, we had someone doing the best he could with the information and experience he had and doing well in the process. Like someone with undiagnosed high blood pressure though, he was sitting on a ticking time bomb that could of been devastating to him and his family. I’ve seen situations where someone has been caught off guard like this and lost a fortune because they didn’t know any better. The experience was so traumatic for them that they abandoned all of the good strategies they had used previously that helped them become wealthy in the first place. What they were left with were poorly designed, speculative gimmicks who offered the hope of earning fast returns they could use to make up for their losses. Or, the other options they had to work with were low-paying, super conservative guaranteed options, which also included the guarantee that they would never earn enough to earn back all the money they had lost.

That’s why having an experienced CERTIFIED FINANCIAL PLANNER™ Professional on your team is helpful. He can keep you from making the mistakes that others make and build a game plan centered around your goals. That approach can make all the difference, but it still has to be implemented properly to be effective.

That takes us to our next situation.

Even the pros make mistakes In this scenario, I was talking with someone who I had helped in the area of college planning. We knew he wouldn’t qualify for any need-based financial aid, so we had never really looked at the details of his financial circumstances to see if there were any ways to improve on what he was already doing. He was pretty sophisticated as an investor, but he also realized that he didn’t know what he didn’t know.

For years he had been working with a CERTIFIED FINANCIAL PLANNER™ Professional who had designed an investment allocation strategy for him. In the past they had both occasionally discussed his goals and his timelines, but I found that the allocation method he had been using to help this client reach his goals could have been implemented better.

Just like in the first situation where someone had come up with their own mix of investments and ended up with roughly 80% of their holdings in the market, this client also had 80% of his holdings in the market too. The difference is this time he was aware of it and thought that having 80% of his savings in the market was necessary for him to reach his financial goals.

As we reviewed his holdings and looked at the details of how his allocation recipe was put together, I found that in addition to having 80% in the market, he also had a majority of larger sized companies in his mix and a tilt toward having more value-oriented companies in play than having a focus growth-oriented companies. Normally that’s a pretty good sign and I expected to find his risk levels to be very much in line with that 80% “in the market” number.

To both of our surprise though, I found that his actual risk level compared to the market was around 96%, not 80%. That wasn’t bad by itself. It was just surprising.

So then, like the other scenario I told you about, with this higher level of risk I expected to find higher levels of return to match it. Unfortunately, though, that is not what I found.

Even with taking 96% of the market’s risk, this particular gentleman had only been earning about 72% of the market’s returns. Once again we had an imbalance between having too much risk and earning too little in exchange for taking those risks. And that was even with a well-trained professional calling the shots.

How to hit the mark more consistently So you may be asking yourself, “How does this happen?” That’s what he wanted to know too. So we looked a little deeper…

In a recipe, like for a cake or a batch of chocolate chip cookies, you find that there is a list of ingredients that have to come together in specific quantities. Depending on what objective you have in mind when you begin, that determines which recipe and which ingredients you choose. A good recipe carefully followed every time with good ingredients will almost always produce the result you intended. That’s the science part of the process.

If, however, you’re following a recipe that’s proven to be a winner, but you decide that you like more or less of something than the recipe calls for, now you’re adding an element of art to go with the science in your recipe. There’s nothing wrong with doing that, but by deviating from a proven formula, you’re opening yourself to unknown outcomes. In the investment world, we call that taking risks. And taking risks can be risky, right?

So, as we looked deeper into the way this 80% “in the market” recipe was implemented, I found some important discrepancies there that can sometimes be mistaken for prudent diversification moves. These ingredients in the recipe had higher levels of risk and a history of producing lower levels of return, neither of which helped make the final product better for this individual. Just like before, rebalancing some of these asset classes and eliminating some of the others altogether improved the risk and reward relationship significantly.

And also, just like before, the questions came up of whether or not having an 80% “in the market” strategy was the right strategy to begin with given his level of wealth, his family’s goals, and his proximity to retirement. It was then and only then that he mentioned how his planner had said that he should be fine as long as “everything went according to plan.”

Well, I don’t have to tell you that everything always does go according to planuntil it doesn’t.

If you’ve been reading my articles or listening to my podcast for any time at all, you’ve also heard me say that we can’t rely on the stock market, banks, or the government to make our financial plans reality. It takes a well-designed plan, an understanding of how proper allocations work, and the proper implementation of the strategies and tactics that bring about a greater chance of success to truly bring about lasting financial security.

That’s what I wanted this gentleman to talk to his advisor about to see what solutions they could offer compared to what I had shown him. Hopefully they can find a way to fix this problem and improve his results, but if not, at least he now knows that there is a better way to protect his financial health and not be caught off guard, like he could’ve been had we not reviewed his situation.

The diagnosis and the cure Let me wrap up here by saying a couple of things. First of all, I know everyone tries to do the best they can. After all, nobody wakes up and says, “You know, today I think I’m going to try to do the third-best I can instead of doing my absolute best.” Nobody does that. Instead, everybody tries to find their way as best they can with the information, knowledge and resources they have.

Studies show that working with a professional, like a CERTIFIED FINANCIAL PLANNER™ Professional who understands investment allocations and who can truly design a financial plan based around your goals, is a more effective way to get better results than doing things on your own or working with any other kind of financial advisor - which is oftentimes just a broker interested in making commissions from your account.

That leads me to the second point. A true CERTIFIED FINANCIAL PLANNER™ Professional’s primary purpose is to serve people by putting their best interest first. I believe in the second situation I described to you today that this gentlemen’s advisor is acting with his best interest in mind. The planner is just not executing the strategy as well as it could be done and that is creating some inefficiencies that could be improved with a little more attention to detail.

You may have noted in my recommendation to him that I did not say for him to transfer all of his business to me. That’s the type of move a broker makes because they need money under management in order to do transactions and earn commissions. Fee-only Registered Investment Advisory firms like mine also make money based on having assets under management, but in this situation it seemed to make more sense for the client to try and improve his results where he was. That was in his best interest, not mine.

Financially speaking, I would have made more money by asking him to move his accounts to us, and depending on what he and his current planner decide to do or not to do, he may still eventually work with us. But, my primary focus was on meeting his needs and serving his best interests instead of my own. That’s what your financial advisor should do for you and if you’re not currently feeling like things are going that way, it may be time for a change.

Don’t let the silent killer of poor investment allocation or poor implementation ruin your financial health. Having the right approach and having the right advisor to help you along the way can keep your financial dreams from turning into nightmares. You may have heard it said that you have to dig your well before you’re thirsty and in the same way you have to make sure your allocation mix is handled properly BEFORE the markets collapse.

Don’t be caught by surprise. Get your accounts reviewed by an independent Registered Investment Advisory firm today. If you don’t know of one already, you can request this type of free review from us. I’ll walk you through the process to show you what you have versus what you think you have. And, just like in the situations I shared with you today, once you have that information, you can look and see if that’s where you really need to be and then make any adjustments necessary while there still time.

Take your health seriously and make your financial health a priority too. You’ll need both to live your best life possible.

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