This year on the Cordant blog, we’ll be answering questions that we frequently see, or that relate to a relevant topic for many readers. We'll kick if off with the following question about structuring a competition between two investment managers.
Question: I will retire in one year. My 401(k) will be sizeable enough that I'm thinking of splitting it in half and giving a portion to two different investment companies. I will give them the same expectations I have in terms of risk and goals. I then plan on waiting a year or two and give my total business to the company that provides the largest gain in their respective portfolios. Is this a good strategy? Why or why not?
Congratulations on your upcoming retirement, but please, please, please don’t risk it with this strategy. Here are three reasons why this is not only a bad idea but quite risky as well.
First, one year (or even two) is not long enough to determine superior investing skill. Some of the best investment managers in history have long stretches of underperformance. In fact, it’s precisely this willingness to be different (and therefore underperform in some periods) that allows them to outperform in the long-term.
Take Warren Buffett, considered by many to be the greatest living investor, as an example. According to Newfound Research, “From March 1980 to October 2016, Berkshire Hathaway A Shares delivered an annualized total return of 20.2%, 9.7% more per year than the Vanguard S&P 500 Index Fund (ticker: VFINX) over the same period.” But, “Even the great Warren Buffett has lagged the market one out of every three years" including longer periods of serious underperformance (see below).
Next, —and this is where the risk of a strategy like this ramps up — consider the incentives you are creating for the two selected investment companies. Neither company has downside in your plan; they either agree to the deal with a chance to win all your business (the upside), or they don’t get the business and are no worse off than they are today. You, on the other hand, are literally risking your retirement savings.
To win your business the managers must outperform, but there's no danger to them if they don't. Therefore, you are creating an experiment with an incentive for the manager to take a lot of risk and swing for the fences. Their mindset is going to be: “Hey, if the risky bet works out, great! I’ve earned the business. If not, oh well—I didn’t have the business anyway.”
Now, there might be plenty of advisors and investment managers who wouldn’t take on excess risk with your money, but these are the same ones who wouldn’t take the bet in the first place. So, why risk your retirement saving with this competition?
And finally, this period close to your retirement date isn’t one where you can afford to increase the risk you are taking. The research shows this is a period of maximum vulnerability. Known as the sequence of returns risk, large losses early in your retirement period, when you have the higher number of years ahead of you to be withdrawing from the assets, is much worse for your financial health than losses later in life. See the following chart from MFS research.
Source: MFS Research – Insightful Investor
If fact, some research suggests decreasing portfolio risk around one’s retirement date and then increasing it once you move further out from this date.
You would like someone to manage your retirement savings, and you'd like to get the best results possible—clearly a reasonable request. However, instead of risking your retirement on this experiment, I’d encourage starting with the following criteria:
- Specialization: Look for a financial advisor that specializes in working with someone like yourself—a recent retiree or corporate employee for example.
- Relationship: Make sure you can connect with your advisor and have open, clear and direct communication with them.
- Goals and objectives: Seek out an advisor that spends the time necessary to understand your goals, objectives and the reasons you are investing in the first place. We use our Financial Blueprint to guide this conversation, but be wary of an advisor who skips this step and just tries to sell you on their investing approach.
- A strategy you believe in: And lastly, make sure your investment strategy is based on the evidence, not someone's predictions of the future. As we saw with the Buffett example above, any strategy has periods of underperformance. An investment strategy built on a solid foundation increases the odds that you will be able to stick with it for the long-term.
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