The average investor underperforms the markets, in part due to psychological factors. Here’s how you can boost your investment confidence to help meet your retirement savings goals.
While the S&P 500 gained 8.21% over the 20 years through 2012, the average investor in equity funds gained just 4.25%, according to a recent study.1 Psychological factors accounted for half of the underperformance, including a fear of portfolio losses that drove investors to make poor decisions about when to buy and sell. Selling investments in a falling market locked in losses and left investors with the challenging decision of when to reinvest. In most cases, investors could have avoided these tough choices by having the confidence to ride out the storm and stay focused on their long-term plans. As a result, the portfolio loss they experienced would have been temporary, and likely followed by gains. While past performance cannot guarantee future results, history has shown that, in the long term, investors who stayed in the market typically ended up ahead.
"Humans are hard-wired to see patterns, so we interpret a momentary drop in the stock market as the start of a pattern of future market declines," explains Stuart Ritter, CFP®, a senior financial planner with T. Rowe Price. "While the emotional responses to the patterns we see are real enough, the patterns themselves often are simply a matter of misperception."
So how do you correct your perceptions? Shift your focus away from short-term trends to your long-term strategy. Understanding the risks that underlie your plan can help build your confidence in the strategy you’ve chosen—and forestall your need to act on emotional responses that may pull you off track.
THREE TYPES OF PORTFOLIO RISK
The long-term strategy you’ve established for your retirement savings is based in part on addressing the major investment risks you face:
Market risk is the possibility that your portfolio’s value will drop due to short-term market declines.
Longevity risk is the chance that you will live a long time, and thus outlive your assets.
Inflation risk is the corrosive impact that inflation has on your retirement dollars’ purchasing power.
Each of these risks can affect your portfolio on a different time frame. For example, you won’t feel the effects of longevity risk for decades. Meanwhile, inflation risk accrues slowly, eroding your savings gradually over time. Finally, market risk shows up right away, when your account balance drops after a market decline. But since humans are acutely sensitive to losses,2 market risk often pushes its way toward the top of investment concerns.
Your strategy for creating an appropriate balance among these risks depends on your time horizon—the length of time to your retirement and the time you’ll spend in retirement. "The longer your time horizon, the more you must protect yourself from the long-term risks," says Ritter. "The shorter your time horizon, the more relevant the short-term risks are."
You can combat the most relevant risks for your time frame by making changes to your asset allocation—the mix of stocks, bonds, and short-term investments in your portfolio. For instance, when you are decades away from retirement (or even at retirement age, with decades of life ahead), your portfolio is more exposed to inflation and longevity risk. Targeting a higher allocation to stocks maintains the growth potential of your portfolio, helping protect your investments against those long-term risks. "Since you don’t need to access that money right now, short-term volatility should have less of an effect on your decisions," says Ritter. "It likely won’t have much effect on the balance of your account decades from now."
The balance between short- and long-term risks will shift as your time horizon shortens. But even when you retire, you’ll still need the growth potential of stocks to help your savings stay ahead of inflation and longevity risks for decades. Depending on your goals, this means holding approximately 40% to 60% of your portfolio in stocks, even as you enter your retirement years. (See "Your Time Horizon and Asset Allocation" for more information.)
Forgoing stocks, or reducing your stock allocation substantially, to avoid market risk may feel like a sound investment strategy, but it neglects to address the full array of risks your investments face.
T. Rowe Price Asset Allocation Funds
Asset allocation funds provide a variety of investment types through a single, professionally managed security.
Asset allocation funds offer a complete investment portfolio, with the benefits of professionally managed asset allocation, diversification, and rebalancing, in one location. The right kind of fund for you will depend on a variety of factors, including your goal and how involved you want to be in making ongoing changes.
Target Date Funds offer an opportunity to automate your retirement investing so you remain appropriately allocated through retirement. In addition to the original Retirement Funds, T. Rowe Price now offers Target Retirement Funds, which seek to reduce volatility as you near retirement by giving up a small measure of growth potential.
Spectrum Funds concentrate on growth, income, or international investments for broad diversification.
Personal Strategy Funds invest in a predetermined mix of stocks, bonds, and short-term investments for growth, income, or balanced approaches.
The principal value of the Retirement Funds and Target Retirement Funds (collectively, the "target date funds") is not guaranteed at any time, including at or after the target date, which is the approximate year an investor plans to retire (assumed to be age 65) and likely stop making new investments in the fund. If an investor plans to retire significantly earlier or later than age 65, the funds may not be an appropriate investment even if the investor is retiring on or near the target date. The target date funds’ allocations among a broad range of underlying T. Rowe Price stock and bond funds will change over time. The Retirement Funds emphasize potential capital appreciation during the early phases of retirement asset accumulation, balance the need for appreciation with the need for income as retirement approaches, and focus on supporting an income stream over a long-term retirement withdrawal horizon. The Target Retirement Funds emphasize asset accumulation prior to retirement, balance the need for reduced market risk and income as retirement approaches, and focus on supporting an income stream over a moderate postretirement withdrawal horizon. The target date funds are not designed for a lump-sum redemption at the target date and do not guarantee a particular level of income. The key difference between the Retirement Funds and the Target Retirement Funds is the overall allocation to equity; although they each maintain significant allocations to equities both prior to and after the target date, the Retirement Funds maintain a higher equity allocation, which can result in greater volatility over shorter time horizons.
photograph by Anastasia Pelikh/mediaphotos