HOW TO CHOOSE YOUR INVESTMENTS

Before I tell people which funds you should own in your 401(k), I would like to explain what makes one fund better than another—what factors to consider when comparing investment options. We need to look at the “why” behind  the decision—the important factors that should guide your choices. 

I will be telling you which funds are the best funds, but as the famous proverb goes, I don’t want to just give you fish. I  would rather teach you how to fish. 

If everyone had the same criteria for deciding which funds to own, every- one would select the same funds, right? 

Therein lies the problem. People have different reasons for their selections. That is another outcome of all the confusion  and noise in the investing world. 

It’s not just people without any training who choose different investments. Ask four so-called experts and you’ll get  four different answers. That tells you a lot about the investment world. 

We’ll get to why the experts make different choices in a minute. But let’s cover the real factors that should be driving  your investment decisions. 

The decision process is much simpler than you think— or at least it should be. You should be selecting your  investments based on CONSISTENT AND RELIABLE  LONG-TERM RESULTS. Period. 

It should be all about the numbers—about which  investments have the best odds of producing the best  and most consistent returns in the long run. 

But what does that mean, and what data should we be looking at? 

The most important statistic to measure any investment  is its annual rate of return. For example, a bank savings  account that pays 4% per year has an annual rate of  return of 4%. 

For any investment, data is readily available regarding its  annual rate of return over various time periods. Notice  how I just introduced another factor into the equation— the time period to evaluate. 

For investments, unfortunately, people too often  look at very recent or short time periods to evaluate  performance— for example, six months or the last year.  Your 401(k) statements highlight this data, so it’s very  natural. 

However, six-month performance or one-year performance does not tell you much about an investment.

If you’re 45 years old, you won’t be retiring for about 20 years. And you won’t be withdrawing all of your  money from your retirement fund when you reach age 65. If you live until the age of 90, your retirement  fund needs to last another 25 years after you retire. So, a 45-year-old person wants to get the best investment returns over twenty to thirty years on average.

When you’re comparing investment performance, therefore, you want to look at performance over at  least 20 years, and even 30 or 40 years. 

Using longer periods of time smooths out the ups and downs that can happen in shorter time periods like  one year or even three years. Don’t give too much weight to short-term performance. 

The next factor is CONSISTENCY. Let’s say two different investments (fund A and fund B) have similar  annual returns over the last 20 years—both at around 8% per year. But fund A achieved those 8% returns  much more consistently than fund B. Fund A had a range of annual returns over the 20 years that included  its worst year with an annual return of 2% per year and its best year had an annual return of 14% per  year— all of the time periods averaged out to 8% per year. 

Fund B achieved most of its gains fifteen to 20 years ago. Fund B was averaging 40% annual returns back  at the beginning of the time period. But in the last five years, fund B was losing money at a rate of about  10% per year. 

Both funds have the same 20-year average annual rate of return of 8%— but they got there in very  different ways. Which fund would you prefer? If you said fund A, you’re correct. 

Fund A has a much more predictable rate of return as compared to fund B. And we care most about the  future returns of an investment. Because of its consistency, fund A’s returns are more dependable. 

Let’s now cover the last factor to consider when picking your investments: how well you understand the  investment. Understanding an investment is not just about knowing what it is, it’s also about knowing  why it increases or decreases in value. 

Bitcoin had an annual investment return of 47% between January 2020 and October of 2023. Pretty  amazing, right? But let’s look at some details about this short period of time. 

From January of 2020 to November of 2021, Bitcoin had an average annual return of 210%. Wow! But from  November of 2021 to January of 2023, Bitcoin dropped in value at an average annual rate of -68%. Since  the beginning of 2023, Bitcoin has doubled in value. Talk about a roller coaster ride. 

The issue of understanding an investment overlaps quite a bit with the last topic—consistency of  performance. Bitcoin is a perfect example of both. 

The point I am trying to make here is that nobody understands how to value Bitcoin – nobody. Many of  us understand what Bitcoin is—a cryptocurrency that trades on the new blockchain technology. I could  add more qualifiers to describe what Bitcoin is, but I could not tell you what makes Bitcoin go up or down  in value. 

Many people are excited and bullish about Bitcoin, and I get that. But what did they predict the value of  Bitcoin would be back in November of 2021 when it was worth $65,000? I bet none of them predicted that  it would be worth $34,000 in October of 2023, or $17,000 in January of 2023. 

You would have made a lot of money in Bitcoin if you’d purchased it before January 2020 and held on to  it until today. But how would you have felt if you’d purchased it in November of 2021 and lost more than  half of your money? 

Buying Bitcoin is gambling, not investing. There is no consistency or predictability of Bitcoin as an  investment. And nobody understands why Bitcoin goes up or down in value. Clearly the price of Bitcoin is  a function of supply and demand, but what drives the demand side of the equation other than emotional overreactions in both directions? Nobody knows. 

Bitcoin was approved as a 401(k) investment several years ago. I don’t believe that is a good thing.  People should not be gambling with their 401(k) investments. Go ahead and use play money to gamble in  Bitcoin—money that you can afford to lose. Don’t purchase Bitcoin in your 401(k) or IRA. 

The last point I will make about understanding your investments is that knowledge leads to more  conviction. I am totally convinced that the profits of the companies that make up the S&P 500 Index (the  biggest and best companies in the world) will continue to grow at a rate of 8% to 9% per year long out into  the future. That is what they’ve always done and that’s just average growth for any company. 

This conviction makes me very comfortable to own an S&P Index fund no matter what’s happening in  the stock market. Fear and greed won’t influence my investments in the S&P 500. 

Fear would have definitely been a factor for me in 2022 if I had owned Bitcoin and saw it dropping like a  rock. I have no conviction about Bitcoin and would not have known when to sell when it was dropping, or when to buy after it started to rebound in 2023. It would have been a totally emotional decision, and  only luck would have influenced my results. 

You don’t want to rely on luck for your 401(k) investments. 

THE CRITERIA 

You want to pick funds for your 401(k) that: 

• Have the highest long-term annual rates of return (over 20 or 30 years or more). 

• Have consistent and predictable returns over the long run. 

• You understand and have some conviction about. 

  
  

RISK 

When you truly understand your investments, you understand the risks associated with those  investments. Very few investments come without any risk. Understanding the strengths and weaknesses  of any investment is the key. 

Risk is a big focus in the investment industry. Investment professionals are required by the SEC to  highlight risk factors to all of their clients. But I don’t think the industry does a good job communicating  the really important risk factors for investors. 

In addition to the standard disclaimers that everyone needs to communicate (past performance is no  guarantee of future results, etc.), the typical approach of the investment industry is to create a risk  profile for each investor. They run everyone through a series of questions to measure an individual’s risk  tolerance. 

This is basically a measure of how well an individual investor can deal with the “buy and hold” strategy.  They want to know if a person might panic in a stock market collapse. This part of the process is a  good thing. It’s important to know if some investors can handle investing in the stock market or not.  Some people cannot stomach even small short-term losses to their accounts, and they would not be good  candidates for stock investments. 

Highly risk-averse people have limited investment options and end up with significantly lower retirement  nest eggs. As long as they’re aware of the implications, it’s their choice. 

But the investment industry takes it one step further and assigns everyone a “risk score.” They then  match that score to an investment strategy. Someone with a very high risk-tolerance (not afraid of short term losses) would be set up with a more aggressive investment strategy consisting of mainly stock  market investments. Someone with an average risk tolerance score would be set up with a less aggressive  strategy such as a blend of stocks and bonds.

I find this aspect of risk profiling to be silly. First, this scoring process gives the impression that the  investment industry has the power to limit investment losses in a very exacting way—that it can somehow  dial in the perfect asset mix for an individual, so that they achieve a specific investment return tied to a  specific level of volatility and risk. But that isn’t possible. 

The risk profiling process is a very clever way to shift responsibility for investing results from the financial  advisor to the investor. In this process, the investor is “designing” the investment strategy, in a sense,  because that strategy is determined by his or her risk profile. So, it then becomes the investor’s “fault”  when the mediocre strategy produces mediocre results. 

The process also focuses on the level of fear that each person has regarding investing, which takes the  conversation in the wrong direction. The process should be used to explain all of the important kinds of  risk associated with investing. With a more in-depth and complete discussion of investing risk, investors  would be in a position to make better investment decisions. 

Too much time is spent by advisors on risk tolerance and fear—and not enough time is spent linking  different kinds of risk with the expected returns of particular investments. Some investments do carry  a lower risk of short-term loss, but they also come with much lower investment returns. And the risk of  short-term loss is very different than the risk of long-term or permanent loss. That distinction should be  made very clearly. 

Most of all, the risk of not choosing investments that consistently perform well over the long term is  the biggest risk of all—the risk of missed opportunity—and the investment industry gives precious little  attention to that risk. 

Let’s talk about the different kinds of risks that investors really need to understand and consider when  making investment choices. There are three kinds of risk that I would like to explore with you. 

1. The first risk to consider is the risk of short-term losses from a particular investment. 

2. The second risk to consider is the risk of long-term or permanent losses from a particular investment. 

3. And the last risk, which is not talked about enough, is the risk of generating low investment returns  in the long term, which leads to insufficient retirement accounts when people reach the age of 65. 

   
   

The investment industry usually lumps short-term loss risk and long-term loss risk together in discussions  with clients. They’re two different things, and this needs to be understood by all investors. 

Most investments other than cash or guaranteed income funds carry the risk of short-term losses,  because all financial markets are volatile. The stock market can and does go up and down on a regular  basis. That risk is well understood by most investors. 

In 2022 and 2023, investors learned that bonds can and do lose value in the short-term. Financial  professionals who do risk profiling will often move investors into bonds if their risk tolerance is low.  Those investors were probably not expecting to suffer through short-term losses in their bonds of roughly  20% in 2022 and 2023.

There is a big difference, however, between short-term volatility—which produces short-term losses— and bad investments that lose money in the long term. 

Long-term losses or permanent losses happen when someone invests in an individual stock and that  company goes out of business or loses significant portions of revenue to a competitor. Long-term losses  can also happen when someone invests in a stock fund that represents a particular devel- oping country,  and that country goes through political upheaval. Long- term losses can occur when a commodity like oil  is replaced by another form of energy. 401(k) and IRA investors should avoid any investment that carries  a high risk of long-term loss. Permanent long-term losses can destroy your retirement plans. 

The last risk factor—the risk of low long-term investment returns— is the risk that’s not talked about  enough. Bonds do provide a little less short-term loss risk than stocks. But that lower risk of short-term  loss comes at a cost: investors are dramatically increasing the risk that they will not create an investment  account with enough money to retire comfortably and securely. And investors need to know that lower  short-term risk does not equal no risk. Bonds lost a lot of money in 2022 and in 2008. 

If you look at long-term investment returns, there’s a huge difference in performance between bonds and  the best stock investments. The best stock investments can produce average returns of 9% to 10% per  year or more. Bonds, on the other hand, can only be expected to produce average returns of 4% per  year—less than half of the gains from stocks. This difference in performance means that a stock investor  will end up with millions of dollars more in retirement than a bond investor. 

If I only considered the risk of short-term and long-term losses, I would rank assets as follows, in order of lowest risk to highest risk. 

1. Bond Funds 

2. S&P 500 Index Funds 

3. Nasdaq Index Funds 

4. Small-Cap Index Funds 

5. Commodity Funds and international Stock Funds 

But when I factor in the risk of low returns and a disappointing retirement account, I would rank the  assets differently. I would now consider the large-cap stock index funds to carry less risk than bond  funds. 

1. S&P 500 Index Funds 

2. Nasdaq Index Funds 

3. Bond Funds 

4. Small-Cap Index Funds 

5. Commodity Funds and international Stock Funds 

Notice how small-cap stock funds, commodity funds, and international stock funds carry the highest  risk factors on both ranking approaches. 

HOW NOT TO DECIDE WHICH FUNDS TO SELECT 

We just covered the factors that should influence your investment picks for your 401(k). Here I want  to also cover how not to choose your fund picks. The following sources are, unfortunately, what many  people rely on when picking their 401(k) funds. 

1. Advice from friends, coworkers, neighbors, or family members. 

2. Your HR department. Are the people you talk to in your HR department highly skilled and successful  investors? No. They’re instructed to avoid giving investment advice. 

3. The financial media. With all the conflicting and confusing information out there, how do you choose  who to follow in that world? The financial media gets clicks by pushing attention-grabbing stories. 

4. (This is why most financial stories are of the doom-and-gloom variety. Train wrecks get more attention than good  news in the media.) 

5. Classic old investment industry strategies. The strategies and solutions currently provided by the investment  industry have been around for 70 years. They didn’t work back then, and they don’t work now. I must say that their  strategies will usually keep you from doing something stupid, but they won’t maximize your retirement account.  They peddle middle-of-the-road strategies that will not produce the money you need to retire comfortably and  securely. 

6. A financial advisor. Financial advisors are mostly indoctrinated in the investment industry strategies just  mentioned. They’re starting with mediocre investment strategies and tend to use them even more conservatively  because they’re worried about getting sued. The result is a lackluster 401(k) balance. Financial advisors are great  resources for tax planning, insurance, and other complicated financial issues. They’re not highly skilled investors.  They’re financial generalists. 

7. Your emotions or your gut. Relying on your emotions or your gut is gambling and not investing. You’ll be right  sometimes and wrong sometimes, and in the end, you’ll make less money than you should. 

   
   

S&P 500 Index funds are great investments, but owning one of these funds does subject you to the irrational and  dramatic ups and downs of the stock market. Knowing that helps you to be more patient during periods of stock market  volatility. So does knowing that the stock market always goes up in the long run.

Stay Disciplined My Friends,

Phil

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Disclaimers The Beyond Buy & Hold newsletter is published and provided for informational and entertainment purposes only. We are not advising, and will not advise you personally, concerning the nature, potential, value, or suitability of any particular security, portfolio of securities, transaction, investment strategy or other matter. Beyond Buy & Hold recommends you consult a licensed or registered professional before making any investment decision.

Investing in the financial products discussed in the Newsletter involves risk. Trading in such securities can result in immediate and substantial losses of the capital invested. Past performance is not necessarily indicative of future results. Actual results will vary widely given a variety of factors such as experience, skill, risk mitigation practices, and market dynamics.