How to best invest for retirement is one of my favorite topics in the financial world, for sure. It is something that I have been discussing and studying for decades, going back to 1997 when I was on the finance committee at Georgia Tech. and we were managing money. At GT, our club outperformed about 90% of all mutual fund managers at the time. In this article, we will be focused on several different key areas, for instance, how to best invest for retirement and controlling expenses, however, most of the discussion will be on diversification.
Diversify Like King Solomon (Net Worth Estimated at $2.2 Trillion in today’s dollars)
One of my favorite verses in the entire Bible is
Ecclesiastes 11:2, which says, "Invest in seven ventures, yes, in eight; you do not know what disaster may come upon the land."
This verse, I believe, is talking about money and not something allegorical. So if we want to invest like the wealthiest man that has ever lived, we want to focus on diversification. This is a topic that I have been passionate about since I was in college. My dad was involved with selling precious metals and real estate, so he always taught me the importance of this verse and how real estate and gold, which are both tangible assets, could be used alongside stocks and bonds to give someone a more diversified portfolio and therefore a smoother ride over a long period of time.
One of the greatest advantages of diversification is that it greatly reduces large drops in a portfolio. Large drops impact a portfolio's long-term return more than anything else. And let me give you an illustration of how this works. If someone has $100 and their portfolio goes down 50%, it is obviously going to go down to 50. However, to get back to 100, it cannot just go up 50% or that will just end up being $75. In order to get back to 100, the portfolio would need to go up 100%. The $50 would need to grow by 100% in order to get back to 100. This is an illustration of how diversification can help you as an investor and generate a better return because you avoid huge drops that we see in almost all inflationary asset classes. Inflationary asset classes include precious metals, real estate, stocks, and commodities.
Correlation to the S&P 500
The way that an investor goes about diversification is extremely important. There are different types of diversification. You could own 5,000 global stocks and your portfolio could still be highly correlated to the S&P 500. That is our benchmark, the S&P 500. We want to look at this index as we are talking about correlation. You should buy assets and put them in your portfolio that have a moderate to a low correlation to the S&P 500 if you want a truly diversified portfolio and therefore a portfolio that is much more resilient under different types of market conditions.
When we look at international stocks located outside of the United States, they have a remarkably high correlation of about 0.85. Thus, buying international stocks is not really going to give your portfolio much diversification from the total US Stock Market. However, there are some assets like gold that have no correlation to the US Stock Market. And it is something that you can use inside your portfolio to give you excellent diversification. Gold had a compound annualized rate of return from January of 1972 to April of 2021 of 7.64%. So it offers nice growth potential in addition to fantastic diversification away from global stocks. Another way to get diversification is, of course, with US bonds, which also have no correlation to the S&P 500.
US Bonds at or Near A Peak
Where we are right now with bonds is a very unusual place. Bonds have been in a 40-year bull market, starting back in the fall of 81, where the 10-year US Treasury bond was paying around 15 or 16% per year. Now (May of 2021) the 10-year US Treasury bond is paying around 1.63%. So interest rates have been steadily declining for about 40 years and this means that bonds have been in a bull market. Bonds still offer investors what they were always meant to offer and that is capital preservation. Many people are concerned that we are going to have inflation and interest rates are going to go up. Which are two very different things.
The Difference Between Economic Inflation and Price Inflation
If we have inflation prices of the goods around us; our gas, our home prices, our food, our healthcare, those could all inflate. Our consumer price index could go up. However, that does not mean that interest rates go up. Interest rates were raised in the 80s because the baby boomers were graduating from high school and college and creating mass numbers of jobs setting records that the United States has never seen before. Few countries in recorded history have seen an increase in its adult population as we saw in the United States back with the baby boomers when they were graduating from high school and college in the 70s. So when they are creating all these jobs, they are creating all this income, which is driving up our GDP or gross domestic product of our country by a tremendous amount.
Now the gross domestic product is the amount that our country is selling in goods and services in a given year. They measure that number for the entire United States. And so that is where you see the economy heating up, and that is the type of inflation where you have a GDP growing at a rapid rate where the government can afford to raise interest rates. I do not think that the global governments can afford to raise interest rates right now without cratering the entire global economy.
Another really good asset class for diversification is foreign bonds. This will give you some exposure to not only foreign currency if you buy an un-hedged mutual fund or ETF in foreign bonds, but the correlation is low, it is about 0.25, and that is going to have a little amount of correlation to the US Stock Market, which will offer you excellent diversification.
The final type of asset that I want to talk about is the defensive stock group. It is the most defensive sector and has the lowest correlation to the S&P 500 of any of the other sectors. And that is utility stocks. These are stocks with companies that provide electricity and other types of utilities to citizens in our country. This type of mutual fund or ETF is going to invest primarily inside countries of the US. So this is not something that is going to give you additional foreign or international exposure. However, its correlation to the S&P 500 is about 0.4, which is low to moderate. And it is another way to give your portfolio further diversification, away from the total US Stock Market.
The way that I have described the diversification here is the goal of many of the hedge funds that you see out there, which is to produce a real and smooth return for its investors, regardless of what stock markets do globally. And by using some of these non-correlated asset classes, you too can produce your own hedge fund-like portfolio. That will produce remarkably solid long-term returns.
Keep Expenses Low
The final thing that we are going to touch on briefly is just expenses. There are so many different ways to invest, and if you decide that you are going to invest in mutual funds and ETFs, which could be a great idea for you, then you want to make sure that you use funds which are incredibly low cost. Expenses drag on portfolio performance. And most of the active mutual fund managers cannot produce better long-term returns than just simply the low-cost index funds. Two of the better mutual fund families out there is Vanguard, DFA, and Schwab. All three of these companies have excellent choices for low-cost indexes where you can get exposure and great diversification into indexes at an extremely low cost.
Focusing on expenses inside of your ETFs and mutual funds is particularly important because it is the number one identifier of how a mutual fund or ETF will perform long term. They found in studies that the number one factor in determining a fund's performance was its expense ratio. It was more of a factor than any of the other factors that they used in order to calculate the correlation between a particular factor and that particular fund's long-term returns.
There are many things to look at when considering how to invest in retirement, but diversification and expenses are two especially important ones not to be overlooked by any wise steward.
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