Do you understand the difference in a conservative risk strategy or an aggressive risk strategy? 

In very simple terms cash and money market investments are the most conservative investments. They are conservative, because the objective is to conserve your wealth. You are not risking the principal, so you are paid a very small interest payment. If you need your money in two years to buy a car, a cash or short-term investment strategy may be appropriate. 

Once again in very simple terms investment grade bonds usually carry moderate risk, because a large part of a bond’s return comes from the coupon or interest payment. 

Equities are more aggressive investments.  The return on equities or common stock carries higher risk, because most or all of the return comes from the change in value of the stock itself.   

The goal of both bonds and equities is to grow your investments knowing that you will be taking some risk to your principal. The economy is volatile and bond and stock markets go up and down.

After the recent severe financial crisis, many retail investors lost trust in the investment markets. People were painfully affected by the financial crisis through their investments, their job and/or their home.

Studies show that there is a lack of trust in the investment markets across all ages and wealth levels. A recent study showed that retail investors globally were holding 40% of their assets in cash versus 31% several years ago. So risk levels have become more conservative.

An ICI Investment Company Institute study showed that 74% of people under the age of 35 stated they were unwilling to take above average or substantial risk with their investments. Another study stated that people between the ages of 22 and 32 said they chose to put 75% of their retirement savings in cash and bonds and only 25% in equities.

After living through the financial crisis a conservative approach to investing is understandable. However, if investors’ reluctance to invest in the stock market continues many investors will come up short in retirement.

Let’s go through a very simple example. If you are age 35 and you have $10,000 in savings. You invest another $5,000 each year for 30 years. If you hold these funds in your savings account and earn 1% a year your funds will grow to $189,150.

If you take the same $10,000 plus deposits of $5,000 each year and invest in assets that yield a 5% return per year, your assets will grow to $392,000. Obviously investment markets do not return 5% every year, but over 30 years do you believe the markets can return on average 5% each year?

You need to determine what level of risk you can live with and try to balance that out with the amount of return you want to earn.

Your age, your time horizon for the money, your current financial health, your comfort level with risk, and your knowledge of investments impact the amount of risk you are willing to take.

Determine your own financial identity – what are your goals and what is your investment personality? Do your investments reflect that strategy and the level of risk you should be taking?

Some studies have shown that people do not have fear of the investment markets, but they leave their money in savings, because they are fearful of choosing the wrong investment options.

Now you might know the investment mix of equities, bonds and cash you want in your portfolio, but how do you choose the right investments in each of those categories? You may need investment advice. 

Kowalczyk comments: There are lots of rule of thumbs out there on investment mix. One simple one is 100 minus your age to determine an appropriate mix of equities vs. fixed income. Another one is just split your portfolio into 50% bonds and 50% equities.

 

There are two primary methods of investing. One method is active management where the investment manager attempts to beat the market with investment strategy and actively buying and selling investments.

The second method is passive management where investment managers structure investment vehicles that attempt to mirror market indexes giving you the market return of whatever index you are tracking.

Active management is hands on management and costs more than passive management. Index funds, an example of passive management charge an investment advisory fee of around 1/5 of a percentage point for managing your funds. An actively managed fund can charge 1-2% on your investments. To justify the actively managed fee your investment return must out perform the market to make that fee worthwhile.

The actively managed market remains the largest part of the investment management market. So, there are many people that believe they can choose investment managers that can consistently beat the market.

If you are not sure you can choose the right investment managers, another approach to investment strategy is investing in passively managed funds that give you a market return and risk at a lower cost.

Two primary passive investments, Index funds and ETFs have become a larger and growing part of the overall investment market.

Vanguard created the first index fund for retail investors in 1975. John Bogle, the founder of Vanguard, is a strong believer of “you get what you pay for.”

Index funds are mutual funds that are structured to track the return and risk of a major index such as the S&P 500. Index funds are around 11% of the market.

ETFs or exchange traded funds are securities that track an index, but trade like a stock and have become as large a segment of the market as index funds. ETFs are 70% controlled by 3 firms, BlackRock, State Street, and Vanguard.

Investment advisory fees are only one type of fee that is paid by investors. There are also continuing fees and expenses such as fees for record keeping, taxes, legal, accounting, and audit fees.

Mutual Funds publish an expense ratio that is a ratio of expenses divided by the dollar value of the investments. Morningstar and Lipper both track fund expense ratios to help give you some comparisons. Your 401k/403b/457 plan also publishes the expenses it charges you to manage the fund.

So, do you know how much of your portfolio is actively managed or passively managed? Do you know what expenses you are paying on your investments? Are your investment returns exceeding the expenses you are paying?

Kowalczyk recommendation: Investopedia is an easy way to look up investment terms.

Kowalczyk comment: Many young people gravitate toward target date funds in their 401k/403b/457 plan. These funds automatically keep your account balanced between stocks and fixed income investments to an age appropriate level. These funds start out with a higher percentage of riskier assets when you are young and adjust to a more conservative mix as you near retirement.

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