Here is the situation: You’ve been saving for retirement for years, and you now have a meaningful nest egg. You are getting to the age when you realize you need to be properly invested to achieve an enjoyable standard of living in retirement. But what is “properly”? What if you make a mistake?
There are three moves for investing effectively for retirement. First, design your ideal investment portfolio (using asset allocation). Second, implement your design with investments. Third, stick with your carefully constructed portfolio once you’ve built it, so it has time to work as planned.
Instead, I often see investors mixing up their moves. Focusing on investments first, they select the recent best-performing funds. Or they invest mostly in tech or dividend-paying companies. As a result, they inadvertently omit major asset classes from their portfolio, which, if included, can both enhance overall returns and reduce portfolio volatility.
And are your retirement accounts mostly held in index funds? There’s nothing wrong with that. Index funds are built to track the performance of a specific index, like the S&P 500, and can be a great way to inexpensively capture such returns. But did you buy the index funds to implement your thoughtfully diversified investment portfolio, or did the funds you purchased determine your portfolio’s diversification (asset allocation)?
Fund selection is supposed to be your second move, or how you implement your desired asset allocation, after you’ve designed it. Designing an appropriate asset allocation is your first move, because it is by far the greatest determinant of investment outcomes. Implementation (with index funds or otherwise) is of secondary, and much less, significance.
In other words, choosing the best index funds on the planet won’t make up for poor design. Investment success or failure is based primarily on how effectively you’ve allocated your assets across available investment types, including stocks, bonds, cash, and real estate. Then, inside these broad asset classes, it matters how effectively you’ve further diversified your positions into (for example) large versus small company stocks, U.S. versus foreign company stocks, high-quality versus low-quality bonds, and so on.
So, how do you determine the right asset allocation for you and your retirement? That’s a great question, and one I’ll address in my next piece.