How To Understand Your Financial Portfolio Better

Written by: Fargo Inc

Photo by Hillary Ehlen

Thoreson Steffes Trust Company Co-founders Rick Thoreson and Kelly Steffes have more than 50 years of combined experience in the financial industry. As CIO and CFO, respectively, they deeply understand the importance of financial planning and managing money responsibly.

“Many financial plans are based on historical returns because it’s the easiest and most defensible from a standpoint of ‘This is what it was like in the past, so why should the future be any different?’ Well, it’s going to be different because the market doesn’t always stay the same.” – Rick Thoreson

Fargo Inc! sat down with Thoreson and Steffes to discuss the importance of saving early in life, the challenges of diversification, how a financial advisor can help with your financial portfolio and more.

Finances can be a difficult topic for some to tackle. What would you say to someone who wants to get a hold of their finances but doesn’t know how or when to start, and when should a financial advisor get involved?

Kelly Steffes: There are a lot of younger people who think that they’ll wait until their earnings increase to start saving, and they’ll save larger amounts later in life. They don’t understand that starting early, even with a relatively small amount, can make a difference. I’d like people to understand that starting to save early makes a big difference in that it not only becomes a habit, but those savings have a longer time to grow and accumulate.

Rick Thoreson: Every college graduate or high school graduate should develop their own budget. I don’t think it’s ever too early to work with a financial planner, but it can be challenging to find one who wants to work with you when you don’t have any assets. Fortunately, the CFP Board (an organization of Certified Financial Planners) is promoting pro bono and hourly based financial planning as an alternative to the traditional transaction-based fee or assets under management-based fees. That gives younger people more avenues to explore for professional advice. There are also a number of free financial calculators for retirement and college planning offered through websites of financial services companies.

KS: Even if you aren’t talking to a financial planner, there are great apps out there and research you can access online. When I talk to people in their 30s and 40s about financial planning, I’ve been surprised when they’ve said, ‘Well, I’m young and I have plenty of time to worry about that later.’ People need to recognize their own mortality and that they are going to need to retire someday. Planning early is important to provide themselves with financial security during retirement and/or provide their family with financial security in the event of an unexpected death.

RT: One of the best disciplines for young people is contributing to their 401(k) plan. If your employer offers a match, contribute the minimum that maximizes the match. If you get a 3 percent raise, increase your contribution by half a percent or one percent and keep doing that. Many kids think their 401(k) is going to be enough, and it might not depending on how long you live, how much you save and what you earn on it. It’s important to think about how much you’re putting away when you’re younger. Later in life, it’s more critical to get the investment strategy right, but early on it’s much more important how much you’re saving.

The biggest problem we see with individual investors is they tend to look at what’s done well in the past and assume that it’s going to continue. Regression to the mean is well understood by the institutional investors, but not by individuals. Regression to the mean occurs when returns from stocks are well above historical averages, or well below, and the trend reverses. General Electric is a great example. It’s been in the Dow Jones Industrial Average since the DJIA was created in the 1880s, but it got kicked out of the average because the stock has been such a poor performer after being a darling of investors for the previous 30 years. In 2008, it was the second most valuable company in the United States at $350 billion. Today, it’s worth one quarter of what it was 10 years ago. By comparison, Apple was worth about $80 billion 10 years ago, about what GE is today. Apple crossed the $1 trillion mark in September. Expecting the past to be predictive of the future is one of the most common mistakes individual investors make.

Financial advisors need to have conversations with clients, especially during times like the 2008-2009 recession, and ask, “What has changed in your goals? Nothing? Then why should your plan change? We’re invested this way because this was your goal. Yes, we’re in a downdraft, but that happens.” If your goals haven’t changed, your behavior and strategy shouldn’t change either. We didn’t have a single client who changed their plan during 2008 and 2009. We had a couple of clients ask questions about it and we walked them through why they were invested the way we were. That’s when an advisor really earns their keep. It’s not when markets are doing well; it’s when the markets are painful and you get a client to see past it.

How often should people review their financial portfolio after setting it up, and then how often should they make changes, if necessary?

RT: That’s up to the individual, but everyone should review it at least annually. There are clients who behaviorally set it and forget it, and that’s a huge mistake, and then there are ones who micromanage it. They see a little volatility in the stock market and react to it when they shouldn’t.

KS: In regards to when they should make changes, that would be more about personal goals and circumstances. Typically when we purchase stocks, we intend that we’re going to hold them for at least five years. Sometimes changes need to happen sooner, but there is no magical number. The performance of the portfolio and personal goals need to be reviewed and considered as a whole.

RT: During the recession, we had a client who was thinking about getting more conservative. We started talking about the individual stocks in their portfolio and the fundamentals of the companies. That made it easy to ignore what was going on with the stock market and focus on the companies they owned and their business performance. One of the unfortunate changes I’ve seen in the industry is that more clients are less knowledgeable about what they’re actually invested in at the asset class and security level. I think diversification has been overplayed. A good example is high yield bond funds. Bonds are supposed to reduce risk when combined with stocks or equity funds, but in times of financial stress, only the highest quality bonds provide diversification. High yield or “junk” bonds behave more like stocks and can drop in value substantially in a recession because that’s when risk of default rises dramatically.

Clients learn this mantra that diversification lowers risk, but that’s not always true. People sometimes misunderstand diversification. They think the more things they own, the better diversified they are, instead of thinking about diversification as if something happens, what else happens? Financial advisors can either add value by truly understanding diversification or subtract value by throwing money at a little bit of everything. We’ve had clients bring us portfolios that are well diversified in terms of number of holdings, the extreme case being more than 60 different mutual funds in one account. When we look under the hood, the overlap of holdings between the funds overstates the diversification because many of the funds have common holdings. The opposite is also a problem. A large number of actively managed mutual funds is almost certain to underperform a much smaller number of index funds.

Investment strategies vary for everyone depending on their income, financial goals and more, but what are some strategies for helping people better understand and diversify?

RT: Age is one of the most important factors when you’re saving for retirement because you have more time to recover from the volatility of the market when you’re younger. The old rule of thumb used to be 100 minus your age is what you should have invested in stocks, so if you were 60 years old, you should have 40 percent in stocks and 60 percent in bonds. That probably worked when life expectancy was a lot shorter, but now financial planners say it should be 120 minus your age. So at 60, you’d have 60 percent in stocks, but that certainly doesn’t apply to everybody.

Another thing that has changed generationally is debt. Baby Boomers and Millennials are far more comfortable with debt than their parents. A lot of financial planners talk about having a cushion of six months of spending in case you lose your job or something. That’s valid, but this generation is more likely to think, “I don’t think that much cash is necessary because I have a line of credit at the bank that I could always tap if I really need to.”

RT: A major concern Kelly and I share is the practice of building financial plans based on historical returns. Planners often do it because it’s the easiest and most defensible from a standpoint of “This is what it was like in the past, so why should the future be any different?” It is going to be different because markets are dynamic, not static. We build our own expected returns starting with the 10-year U.S. Treasury yield, which is currently about 3 percent compared to historical returns over 6 percent. From there, we add the risk premium you might expect from riskier assets like U.S. stocks or emerging market equities. Basing projections on past returns could overstate expected returns by as much as 3 percent, which has a dramatic impact on outcomes. We’ve had a few prospective clients who have gone to other financial planners because they promised them higher returns and more spendable income based on historical returns. Also, some financial planners will base plans on an average return of 7 percent a year, so their charts show a straight line, but the markets don’t go in straight lines. It’s far more realistic if the software looks at realistic returns, one of the most valuable scenarios being “what happens to my plan if a severe drop in the stock market or jump in interest rates kicks in right after I retire?”

KS: Financial planning software tends to assume that once you retire, your expenses go down. We see the opposite, especially immediately after retirement. Many people spend the first few years of retirement traveling and/or purchasing a second home. Financial planning software also tends to assume that when a person loses their spouse, their expenses get cut in half, but that doesn’t happen either. We find expenses tend to stay relatively level and may even increase. Your home expenses don’t get cut in half because there’s only one person living there. In fact, it may be necessary to hire someone to help take care of the home. There are a lot of default assumptions that are used in financial planning software that aren’t necessarily accurate. If not appropriately adjusted and tailored to the client, the software will generate inaccurate projections.

RT: There’s a new trend in financial planning called robo-advising where you answer questions online and it tells you how you should invest your money to achieve your goals. That can be a great alternative early in life because if something goes wrong in your plan, it can self-correct over time. But when you shift from earning money to living off the money you earned, you shouldn’t trust a computer to answer the questions you should be asking.

How does age impact one’s financial portfolio, and should people invest more at a younger age or are there any other age trends that you’ve noticed?

RT: You should always invest as much as you can afford regardless of your age. And if it doesn’t hurt, you’re probably not saving enough. Two of my favorite quotes are from Albert Einstein, who called compound interest the “eighth wonder of the world,” and Ben Franklin, who said, “Money makes money. And the money that money makes, makes money.”

KS: Not only does it compound, but it also creates a habit. Larger wage earners tend to fall prey to believing that they don’t need to start saving early because they believe they can afford to spend more right now and just save larger sums later. Unfortunately, sometimes they don’t start early enough and are caught off guard.

RT: Age is only one factor. There are a lot of other factors that go into how you build that plan, including earning capacity, the type of career you’re in and more.

I read a Forbes article that mentioned the importance of quality over quantity. It’s easy to want something when it’s trending right now, and nothing is ever a sure thing, but how can people vet potential investments to see if they’re the right fit for them?

RT: Trendy has always been a problem, and a lot of that is just the hype that surrounds it. Peter Lynch wrote “One Up On Wall Street” in the early 80s, and his argument was if people would invest in the things they know, they’d do far better. There’s a certain sense of security in investing in something you know something about.

One of our clients once came in and said, “Why isn’t my whole portfolio in Apple when Apple is doing really well?” I know it was somewhat tongue-in-cheek, but every client in the back of their mind thinks, “Why don’t I have more money in winners?” A lot of the time it’s because the winners get ahead of themselves. We watched Walt Disney go from $30 to $120 from 2012 to 2016, and from early 2016 to today, it’s been flat. There are times when stocks run ahead of what their fundamentals are, and eventually, their price regresses back to the mean.

KS: Another trend we’ve noticed is socially responsible investing. Social responsibility is becoming far more important to clients.

RT: Millennials are different from their parents. One of their fundamental values is that investing is about more than money. It’s about their impact on society. I think that has consequences for financial advisors who ignore it.

Companies who were considered socially responsible used to underperform the broader index, but it’s the opposite now. Companies that actually talk about their impact on the environment, for one thing, are getting awarded a higher valuation from investors because they appreciate that level of social awareness. Now, there’s a market premium placed on companies that are socially responsible. Apple stock did pretty well after they announced that their goal was to get to an emission-free manufacturing process, at least in the United States.

Environmental, social and governance (ESG) investing isn’t a cornerstone of what we’re doing yet, but we’re definitely moving in that direction as it continues to become a greater interest of our clients. We’re waiting for the tools to catch up with the concept because it’s hard to implement until you can actually get companies to start reporting on those issues. The SEC is starting to require reporting of gender diversity within the company, pay equality and carbon footprint. That’s a huge step. I know it’s a reporting burden for the companies, but if we’re going to move forward, it’s important that we start measuring companies on metrics beyond just profits.

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Brady Drake is the editor of Fargo INC!