Jason Stipp: I'm Jason Stipp for Morningstar. We're wrapping up Risk Control Week on Morningstar.com. And this week, we talked a lot about measures of risks, things like volatility, we talked about the Morningstar Risk Rating, we were talking about risks that can happen when you are trading ETFs, we mentioned leverage risks, we even talked about systemic risks. But there's really this whole other set of risks out there that's difficult to capture with the data point.
Here with me to talk about that and what you can do to manage it is Morningstar's Christine Benz. She's director of personal finance for Morningstar.com. Thanks for being here, Christine.
Christine Benz: Jason, nice to be here.
Stipp: So we touched on this in a lot of different places this week, and I think it's one of the more interesting concepts of risks that you really don't hear about that much. You're used to hearing about the statistics, but what is one of the biggest risk factors that's not being measured out there?
Benz: Well, it's behavioral risk and it's the chance that you'll undermine your own returns by doing stupid things with your investments. We spend a lot of time talking about how to find good investments and think about things like low expense ratios and long manager tenures and company quality and so forth.
Well, it turns out the best investments might be investments that you won't do stupid things with or you won't be inclined to make bad timing decisions with. So, I think that this is a risk that investors really need to stay tuned to.
Stipp: So, they can at times be their own worst enemy is basically what your saying?
Benz: They can, and we have a statistic called investor returns for mutual funds and what we see is that consistently investors undermine their own returns with bad timing. So they buy high and they sell low.
Stipp: So there are a few things that you can do to combat your worst instincts. Knowing that we're probably going to be susceptible, especially during times of volatility to make bad decisions. There's a few things that came out this week -- some actual measures that you can take to stay on the right track. One of them is one on the portfolio level, and Harold Evensky spoke about this. It's something called the bucketing approach. Can you explain how that works?
Benz: Yeah, and Evensky was a real pioneer in this idea. But the basic idea is that you have some money that you've set aside, so any money that you need for near-term expenses and planners define this amount differently, but usually it's in the neighborhood of two to five years that you keep in very liquid investments, maybe cash and short-term bonds. And when you have that money set aside, the idea is that you can afford to tolerate some fluctuations in your longer-term investments because you know you won't need to tap them for any near-term expenses.
So, it's a very powerful idea. It's a very simple idea. But it's powerful in terms of segregating a pool of assets knowing that your near-term needs will be met, and so you can let the market do what it's going to do with the longer-term portion of your portfolio.
Stipp: And you're mentioning the longer-term portion of your portfolio; I think another area that we would think about in this case is the time horizon, and the time horizon that you should have and making sure that your time horizon is aligned with what you need, so that you don't make bad decisions. How do you think about time horizon and these mental problems that investors can have?
Benz: Right. So time horizon is very important and very important in driving that asset allocation. So, I am a big believer in long-term and strategic asset allocation and really articulating what your policy is, what your parameters for stocks, bonds and cash are, matching that to your time horizon, and actually taking the step of writing all that down in an investment policy statement.
So here is what I am attempting to achieve, selling only when you see big deviations in your portfolio versus those targets, and also for specific investments outlining specific sell criteria. So, saying these are the things that I will sell based on, and if something happens that's not on your list, that's probably not going to be an impetus to sell.
Stipp: So, almost like a pre-flight check list.
Stipp: So, before you make a decision you check it and you find out what your original criteria were. And just a point that I want to make here, as well, for stock investors. What should be the time horizon that you should at least have if you are even going to consider being in stocks, in your opinion?
Benz: Well, we are through a decade where stock investors really haven't earned anything. So, it seems like a 10-year time horizon for stock investments is very reasonable, because you may need that period of time to achieve a positive return. So, I would say five years at a bare minimum for stockholdings, but better still in the 10-year horizon.
Stipp: Sure. A question for you then I think something else that can help investors stay on track and can actually be beneficial for them is to not have to think about the investments that you are making, that it's automatic. So, how does that work and how can that benefit me?
Benz: Well, I say put as much as you can of your investment portfolio on autopilot, so 401(k) plans work like this already. You are contributing money whether you like it or not, you have to go through some steps to override that policy. Try to do that with any other investments that you can, too. So if you have money flowing into an IRA, average out throughout the year to avoid making that single investment at what in hindsight could turn out to be an inopportune time.
Stipp: So the flip side of that is, then, when things are cheaper you are still going to be buying more shares with that same amount of money that you are investing each time.
Benz: And also I like the idea of doing the same thing with selling. So if investors are inclined to sell something, maybe sell part of it and you may find that you will be able to sell it in a more advantageous point down the line, but I like the idea of doing everything gradually to mitigate that risk of poor timing.
Stipp: Immensely, I think it helps you feel like there is not one critical event …
Benz: I must decide now.
Stipp: …that might cause you to make a bad decision later. And the last question for you, you touched on this a little bit earlier with the investor returns. But really I think that sometimes investors get into things that they shouldn't because the returns looked good and they might be good investments, but the volatility really trips them up.
Benz: Right. So, what we've seen in examining the data on investor returns is a near perfect correlation with higher volatility funds and worse investor returns. So, the more volatile fund types, investors oftentimes get greedy and they look at staggeringly high returns and decide that they want to buy a fund just then, and it turns out that it tanks immediately.
And so, we see this again and again. I say, for most investors, those very volatile investments probably aren't great choices because of that tendency to time them poorly.
Stipp: Christine, thanks so much for the wrap-up on Risk Control Week and for your insights.
Benz: Thank you, Jason.
Stipp: For Morningstar, I am Jason Stipp. Thanks for watching.