Answers to
Practical Questions
What is the Cost of Playing it Safe with Your Investments?
If you are young, being safe with your investments can cost you big time!
Parents, friends, bank employees and financial advisors tell you that, when you start to invest, you need financial advice and you should have a balanced investment portfolio. Well if you know absolutely nothing about investing, have zero interest in learning about investing, and lack discipline, then all those people are right – get a financial advisor and start investing with a balanced portfolio.
However, if you can spend 60 minutes learning the basics, and can teach yourself not to panic in the face of a major stock market downturn, then seeking out a financial advisor and playing it safe with a balanced portfolio for your long-term investments could be one of the biggest mistakes you ever make!
Let me illustrate with an example:
Alice, Betty, and Cathy are triplet 25-year-old sisters. Their dad obviously had grey hair, but I digress. Their late Great Granny never had a lot of money and scrimped her whole life. Granny left each of the three girls $10,000, but with one catch: the money had to be invested until they turned 65. While that seems like an eternity, remember life expectancy is now about 85 and climbing. Great Granny wanted to help her grandchildren have a better retirement than she had.
Alice knows nothing about investing and doesn’t want to know anything about investing. She also once lost $100 in five minutes at a casino, and is now totally risk adverse. Alice loved Great Granny deeply and she really doesn’t want to make a mistake with her $10K inheritance. Alice’s boyfriend’s dad is a financial advisor with a major mutual fund company and he has agreed to take Alice on as a client and invest her $10K. Even better, Alice got a “sweetheart deal” on the advisor/mutual fund fees. Alice’s boyfriend’s dad only charged Alice 2% per year with no additional fees of any kind, whereas the average mutual fund fee alone is 2.2% per year.
Betty is a biz knob, having graduated with a Masters of Business Administration (MBA). Betty learned about the high cost of mutual funds versus ETFs in her investing class, but Betty was with Alice that night in the casino, and was up $200 in winnings before losing it all at the blackjack table. Betty remembers the sting she felt from that loss, and has vowed to herself not to risk everything again. Betty thinks the lower volatility and smoother returns of balanced portfolio are best for her.
Cathy is an artist, her work is her love, but she goes from gig to gig and the pay is sporadic at best. Recently, Cathy visited theansweris.ca for about an hour, read the Six Pieces of the Investment Puzzle and took the Ready to Invest quiz. Cathy is courageous regarding her investments as well as her career. She is going to invest her $10K in equity ETFs; no balanced portfolio or bond ETFs for her.
For fun, let’s fast forward 40 years to when Alice, Betty and Cathy are 65, to see how each of these investment strategies fared. Based on equity returns that average 8% per year, and bond returns that average 4% per year, a balanced portfolio would average 6% per year, (i.e., (50% @ 8%) + (50% @ 4%) = 6%).
Alice – Balanced Portfolio of Mutual Funds and Financial Advisor
Alice didn’t know anything about investing and didn’t want to learn. She also did not want to make a mistake so she relied on her financial advisor and took comfort that her portfolio was invested in a lower-volatility/lower-risk balanced portfolio of mutual funds, (i.e., 50% equity and 50% bonds).
Over the 40 years, the stock market dropped 40 to 50% on four occasions, but Alice’s balanced portfolio dropped only 15 to 20% during those times. The stock market also dropped about 20% on eight other occasions, but Betty’s portfolio dropped only about 10% each time. The balanced portfolio really reduced volatility! Each time her portfolio dropped, her boyfriend’s, now husband’s, dad would call her and tell her to stay calm and not sell into the downturn.
However, financial advisors cannot outperform the market in the long run, and so the financial advisor mutual fund fees of 2% per year end up being a drag on portfolio performance. Over the 40 years, Alice’s $10,000 grew slowly and smoothly to $48,010, or about five times the value of the original inheritance.
Betty – Balanced Portfolio of ETFs, No Financial Advisor
Betty, the MBA biz knob, only invested in low cost ETFs and did not use a financial advisor. Betty used a balanced portfolio of ETFs, (i.e., 50% equity and 50% bond). Like Alice, Betty faced four portfolio drops of 15 to 20%, and eight portfolio drops of about 10%. Each time the market and her portfolio value dropped, Betty had to reread her investment lessons about not selling into a downturn.
Over the 40 years, Betty’s $10,000 balanced portfolio of ETFs grew to $102,857, or ten times the value of the original inheritance! That is more than twice as much as Alice and her financial advisor made! All because Betty used low cost ETFs versus a financial advisor and mutual funds with a 2% fee.
Cathy – 100% Equity ETFs, No Financial Advisor
Cathy invested only in equity ETFs with no financial advisor. Over the last 40 years, Cathy faced four portfolio value drops of 40 to 50%, and eight portfolio value drops of 20%. Nonetheless, over the 40 years, Cathy’s $10,000 invested solely in equity ETFs grew to $217,245, or almost 22 times the value of the original inheritance!
Let’s recap how the triplets did:
| Investment Method | Portfolio at 65 | Increase over Alice and her Financial Advisor | |
|---|---|---|---|
| Alice | Balanced Portfolio of Mutual Funds, and Financial Advisor | $48,010 | $0 |
| Betty | Balanced Portfolio of ETFs, No Financial Advisor | $102,857 | $54,847 |
| Cathy | 100% Equity ETFs, No Financial Advisor | $217,245 | $169,235 |
Great Granny was right to ask the three girls to wait, and Cathy was right to invest in equity ETFs!
The cost of opting for safety through balanced portfolio and investing with a mutual fund financial advisor was $169,235!
Morals of the story
- Beware of your daughter’s boyfriends.
- Volatility (i.e., big drops in the stock market and the value of your portfolio) is the price of long term performance. Accepting the higher volatility and risk of equities can have a significantly positive impact on your long-term portfolio.
- When you are young, seeking the safety of a balanced portfolio of 50% equity and 50% bonds can cost you big time.
- Financial advisor/mutual fund fees of only 2% per year are a major drag on your long-term portfolio performance.
- TheAnswerIs.ca helped Cathy the artist, and it can help you too, if you take 60 minutes to read the Six Pieces of the Investment Puzzle, and take the Ready to Invest Quiz.
Final Thoughts
Cathy accepted the higher volatility and risk of an all-equity ETF portfolio for 40 years. The higher average returns on equities versus bonds, or a balanced portfolio, yielded Cathy a significant advantage over her sisters. Some people may not be comfortable with the higher equity risk and volatility as their portfolios grow. As people get older, they tend to switch from seeking growth to seeking stability.
If Cathy decided to keep 100% equity ETFs for the first 30 years, earning an average of 8% per year, and then for the last 10 years flipped to a balanced portfolio of 50% equity and 50% bond ETFs, earning 6% per year, Cathy would have $180,206! That is still $77,349 more than Betty made over 40 years of with a balanced portfolio of ETFs, and a staggering $132,196 more than Alice made with her financial advisor and balanced portfolio of mutual funds.
More on the impact of investment returns (the cost of safety can get higher, much higher for Betty and Alice)
Between 1926 and 2014, i.e., an 88-year period, small stocks averaged a return of 12.2% per year and large stocks averaged 10.1% per year, so average equity returns were 11.1% per year. Please see Investment Piece #8 for details.
Over the same timeframe, long-term bonds have averaged 5.7% per year and short-term bonds have averaged 3.5% per year, so average bond returns were 4.6% per year.
Based on the above, an average balanced portfolio return was 7.9%, i.e., (50% @ 11.1%) + (50% @ 4.6%) =7.9%.
These returns are much higher than the returns used in the story above. Using these historical returns in the story above would have resulted in the following hard-to-believe results:
| Investment Method | Portfolio at 65 | Increase over Alice and her Financial Advisor | |
|---|---|---|---|
| Alice | Balanced Portfolio of Mutual Funds, and Financial Advisor | $99,046 | $0 |
| Betty | Balanced Portfolio of ETFs, No Financial Advisor | $209,343 | $110,297 |
| Cathy | 100% Equity ETFs, No Financial Advisor | $673,849 | $574,803 |
In a high return environment, the cost of opting for safety through balanced portfolio and investing with a mutual fund financial advisor is a staggering $574,803!
Balanced portfolios offer lower volatility and lower risk. Financial advisors can keep investors from making stupid mistakes. But ask yourself, if you have a long-term investment horizon, what is the cost of entrusting your hard-earned money to a mutual fund financial advisor, and not learning to tolerate equity risk?