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Beware of What You Think You Know

Dana here.

Most investment advisors manage portfolios and benchmark against the S&P 500, a universe of 500 highly liquid stocks. Yet, the market of publicly traded stocks is far greater than 500. According to The World Bank, at the end of 2019 there were over 40,000 publicly traded stocks.

If there are 40,000 stocks to buy, why would so much of the industry focus on only 500 of them?

Well, the goal of most portfolio models is to maximize returns for a given level of risk. Risk is measured by volatility. Popular risk-tolerance questionnaires may try to assess your comfort level with risk by asking you questions like,

If your portfolio was down 20% you would:

  1. Not worry about it
  2. Call your advisor
  3. Jump off a bridge

Yes, I’m being a bit silly, but that is about the gist of the questions.

The media reports primarily on the S&P 500. If the S&P 500 is down 20%, it is easy for an advisor to explain that to a client. However, if the advisor uses a portfolio structure that is vastly different from the S&P 500, it becomes more difficult to explain the variations. Most people think of the “market” as what the media reports on.

Yet the market does not all move simultaneously in one direction at the same speed. The graph below is Morningstar’s Market Barometer. The top row represents the universe of U.S. publicly traded large-cap stocks, where the S&P 500 falls. The 1-year returns have been strong. Yet, look at the bottom left corner, which tracks small-cap value stocks, which had double the returns of large-cap.

 

While small-cap value stocks had outstanding returns over the past year, they also have greater volatility than large-cap stocks. While they may be up more in great years, they can be down more in bad years.

If your primary goal is to build a portfolio with less risk over a one-year period, then you would allocate more to large-cap stocks and benchmark against the S&P 500. And that is how the majority of mainstream portfolios are constructed.

But what if you had a longer time frame? What if you knew you wouldn’t need to sell any of your stocks for 7-10 years? Then, you could build a portfolio around risk parameters over seven years instead of over one year. And turns out, that would lead you to an allocation that would include more small-cap value stocks. You can learn more about how small-cap and other asset classes behave over different time frames in this paper on Visualizing U.S. Asset Class Returns Based on Time Horizons, Size, and Style.

Now, if you wanted to add small-cap value to your portfolio, how would you do it? Turns out mutual funds provide the most effective way to build a broadly diversified portfolio. With a few funds, you can have a portfolio that includes over 15,000 publicly traded stocks, not just 500.

However, mutual funds have fees. And some people think all fees are bad. I recently had a conversation with someone who was quite concerned that we used mutual funds in our client portfolios instead of stocks. If we benchmarked against the S&P 500, we could use individual stocks or an investing process called “direct indexing” and eliminate the fund fees.

However, that portfolio structure is not the one that is best suited to deliver the outcomes we want. And so we use funds. And funds that own international, small-cap, and emerging markets stock have higher fees – even if they are index funds. Yet that is the most effective way to build the portfolios.

Be cautious of judging something just on its relation to the S&P or just on fees until you know the underlying rationale. It may not be for you, but when talking to thoughtful people with well-designed processes, there is typically a reason they do what they do.

In our approach, it is always about how to deliver the best outcome for the client by choosing from the tools available out there. That could be stocks or funds or a plethora of other options. Whatever we use, there is a researched reason we made that choice.

If you are looking for customized advice, you can learn more on the Services page of our website.

We’ve had a tremendous influx of new clients in 2021 and currently have a waitlist for our initial consultations, which we’ll host in the first quarter of 2022. If you are thinking about doing a plan in 2022, we’d encourage you to start the inquiry process now and we’ll get you in the queue.


Our next free online webinar will be on Thursday, January 20, 2022!

Subject:
How to Make a Retirement Income Plan

What we'll cover:
How much will you need to retire, and where will it come from? 

In this class, we will show you how to make a detailed retirement income plan by creating a series of timelines that chart your future income and expenses. You will see how you can put together a crystal-clear picture of your future retirement income. 

We will go over:

  • How to make a retirement budget and the most commonly overlooked expenses
  • What a future income timeline looks like
  • How to calculate how much you will need to withdraw each year during retirement
  • Mistakes people make with their assumptions about inflation and rates of return
  • How to see if your retirement money will last

 
We will leave plenty of time for questions and answers at the end.
 
When:
Thursday, January 20, 2022 5pm AZ/ 6pm CST/ 7pm EST

You can register at: How to Make a Retirement Income Plan


Podcasts & Video

Juicing Your Retirement Plan
Dana and Stan the Annuity Man discuss what Dana refers to as "Juicing Your Retirement Plan". They also discuss four specific strategies for approaching and using the 4% rule for retirement income in this podcast

Juicing Your Retirement Plan

How to Plan for Taxes in Retirement
In retirement, you need to set up your tax withholding or make quarterly tax payments. How can you estimate how much you'll need to withhold and how will it change throughout your retirement years? Watch our last webinar on our YouTube channel. 

How to Plan for Taxes in Retirement



Financial Sense is an almost-monthly publication of Sensible Money. It's about financial planning and smart money decisions, not sensation and hype. You know.... sensible.

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WORTH YOUR TIME.


While the “accumulation” phase is not necessarily complicated, the “decumulation” phase involves more complex interactions between many moving parts. In this course, you’ll learn how to apply a planning process that addresses these complexities so you can be confident you have enough money to last your whole life.

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Sensible Money, LLC · 4200 N Marshall Way, Suite 2 · Scottsdale, AZ 85251 · USA