I am about to tell you something that no broker or money manager has ever told you about your 401K or your retirement investing. It is going to fundamentally change how you view your 401K and retirement investing. It is also something that you have read over and over again on financial planning websites. And it is completely inaccurate.
You are over-invested in stocks, and vastly over-invested in bonds.
I know this will shock many investors, who have learned that “proper” asset allocation means a certain percent in stocks and a certain percent in bonds. That’s simply not true, and if that theory is how your portfolio is even partially constructed, your 401K and retirement investing are in big trouble.
The Risk in Your 401K
The reason has to do with risk in your 401K or retirement portfolio. No matter what any broker or money manager or website says, your portfolio carries too much risk. How do I know? It all has to do with volatility. The more volatility there is in a portfolio, the more risk it has. Worst of all, none of these “professionals” will ever give you details about risk. They just give you some arbitrary allocation of stocks and bonds. Then they send you on your way to invest your 401K or retirement portfolio.
This is why I created The Liberty Portfolio, an advisory newsletter geared towards proper asset allocation. It aims for a real rate of return of 10% with substantially less risk than most other “professionally managed” portfolios.
I’m going to show you how to fix your 401K and retirement investing. First, however, you need to understand how to measure risk.
Measuring Risk in Your 401K
You have heard of “standard deviation.” I know just reading those words makes you cringe. But I’ll keep it simple. Standard deviation is a way of measuring how much confidence you have that a certain data point will fall within a certain range.
Here’s an example.
Imagine you are sitting on your front porch with a radar gun. You are clocking the speed of 10 cars and you log those speeds:
- Car 1: 30
- Car 2: 40
- Car 3: 32
- Car 4: 28
- Car 5: 33
- Car 6: 34
- Car 7: 36
- Car 8: 31
- Car 9: 30
- Car 10: 36
The average speed of the cars is 33 mph. If you use a calculator, you’ll find the standard deviation is 1.3 mph. We also call this “1 standard deviation.”
“One standard deviation” means there is a 68% chance that the next car that passes will be driving at 33 mph plus or minus 1.3 mph. In other words, there is 68% chance that the next car that passes will be driving between 31.7 and 34.3 mph.
“Two standard deviation” means there is a 95% chance that the next car that passes will be driving at 33 mph plus or minus 2.6 mph. In other words, there is 95% chance that the next car that passes will be driving between 30.4 and 35.6 mph.
It is this 95% level of confidence that interests us as investors. We want to have a very high degree of confidence about what our investments might earn. So we always are going to be looking at a stock’s mean return over a certain period of time. We’ll also look at its standard deviations.
How To Fix Your 401K
Calculate the returns for your portfolio and find its standard deviation. I bet that the average return is designed for about 8%, but the standard deviation for your portfolio is incredibly high — probably exceeding 20.
What this means is that your portfolio would have a 95% chance of delivering between negative 32% and positive 48% in any given year. I’m sure you’d be happy if it was the latter, and very unhappy if it was the former.
Wouldn’t you rather have a portfolio that is designed to earn you an average of 10%, with a standard deviation of 8? That is, that it’s designed to average 10% per year, and have a 95% chance of returning between -6% and +26%? I know I would.
The approach to achieve these returns will almost certainly not be in the asset allocation of your 401K or retirement portfolio.
What’s the secret to fixing your broken 401K? Read my article on “non-correlated” assets and pay us a visit at www.thelibertyportfolio.com. The key is to use non-correlated assets to offset risk. And you’ll be surprised to learn that bonds have nothing to do with it. In fact, bonds add volatility to your portfolio.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance, and is the Manager of The Liberty Portfolio at www.thelibertyportfolio.com. He does not own any stock mentioned. He has 22 years’ experience in the stock market and has written more than 1,600 articles on investing. Contact Lawrence Meyers at [email protected]