The Secret to Prudent Retirement Investing

W. Scott Simon is a principal at Prudent Investor Advisors, a registered investment advisory firm. He also provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. Simon is the recipient of the 2012 Tamar Frankel Fiduciary of the Year Award.

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The letter sent to Dr. Stanislaus in last month's column concludes this month:

Fear not, Dr. Stanislaus, because there's good news (at least when you're invested in your current portfolios). Unlike return, which is inherently uncertain and therefore cannot be managed (nor predicted), portfolio risk can be managed through broad and deep diversification (this is what we have done for you in your portfolios the entire time we have invested and managed them).

An essential principle of Modern Portfolio Theory is reflected in the first of five "principles of prudence" laid down by the Restatement (Third) of Trusts: "Sound diversification is fundamental to risk management and is therefore ordinarily required of trustees." Yale University professor of law emeritus John Langbein, the Reporter for the Uniform Prudent Investor Act (UPIA), observes: "One of the central findings of Modern Portfolio Theory [is] that ... huge and essentially costless gains [can be obtained by] diversifying [a] portfolio thoroughly."

As noted, if Big Bank in the past has truly (after costs and risks) outperformed your current portfolios, it must have, by definition, incurred more risk to do so. But why should you care whether the Big Bank portfolios are, for example, riskier? They outperformed your current portfolios, didn't they?

Even assuming that they did outperform--after fairly taking into consideration the factors noted previously--you should care because the same higher risk inherent in the Big Bank portfolios could come back in the future to bite you when you are actually invested in the Big Bank portfolios, thereby resulting in lower return.

No doubt, everyone likes to see their portfolios garner high returns. Few are aware, however, that it's actually far more important to avoid large losses than achieve high returns when building wealth over time. For example, a 10% loss requires an 11% gain to recover from that loss, a 20% loss requires a 25% gain, a 33% loss requires a 50% gain, and a 50% loss requires a 100% gain. Note that as the percentage losses mount up in a linear fashion from 10% to 50%, the percentage gains necessary for your portfolio to offset those percentage losses--to get you back to the original value of the portfolio--grow exponentially from 11% to 100%. As more and more dollars are lost, the percentage gains must grow larger and larger in order to get back all those lost dollars.

By the way, the importance--mathematically--of avoiding large losses comports--legally--with the requirements of section 404(a)(1)(C) of the Employee Retirement Income Security Act of 1974 (ERISA), which commands fiduciaries of retirement plans to diversify "the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so." I cannot think of any circumstances where the investment portfolios in a 401(k) plan such as yours should not be broadly and deeply diversified to minimize the risk of large losses.

In addition to employing broad diversification to manage and reduce risk, standards of modern prudent fiduciary investing require, as noted, the reduction of costs and taxes to enhance return. We needn't worry about taxes since we're in the realm of retirement plans. Hence, the "secret to investing" can be refined even further into just three elements: manage 1) risk and 2) costs to otherwise increase return, and 3) let returns fall where they may because they cannot be managed or predicted anyway. (Of course, the most important factor to building wealth is the amount that you save and invest; even the secret to investing doesn't do you much good if you're saving $8 per year.)

The Restatement suggests that the best way for fiduciaries to implement these elements is by investing passively (this is what we have done for you in your portfolios the entire time we have invested and managed them). "Passive investing" involves investing in low-cost, and broadly and deeply diversified index mutual funds and asset class mutual funds that efficiently and effectively capture the returns offered by financial markets while incurring market-level risk.

I've concluded in my book on the UPIA, as well as in fiduciary columns I've written for Morningstar, that passive investing is, in effect, the default standard of modern prudent fiduciary investing. That is, invest in all the major asset classes of the world's financial markets--thousands and thousands of stocks and fixed-income investments--at a low cost (this is what we have done for you in your portfolios the entire time we have invested and managed them). Such portfolios will broadly and deeply diversify risk and likely afford participants in retirement plans such as you and your colleagues the best chance to retire as comfortably as possible given your particular circumstances.

There will be times, though, that our portfolios will fail to achieve high returns or even achieve positive returns, as has happened over the last few years, which has led you to leave us. One of the trade-offs about that, however, is that in times when financial markets plunge in value (along with your portfolios invested in those markets), your current portfolios will go down in value less due to their broad and deep diversification than the riskier (by definition) Big Bank portfolios. Remember, what's most important in accumulating wealth is to avoid large losses along the way.

When the inevitable market upturn occurs, which is the day after the nadir of a market plunge, your current portfolios will begin to participate in that upswing valued higher than the Big Bank portfolios, thereby likely outperforming them over time. In effect, your current portfolios will dig out of a shallower hole after market downturns than the Big Bank portfolios, thereby gaining more in value in subsequent market upswings and leading to greater accumulated wealth over time.

Reducing risk through broad and deep diversification and keeping costs low tend to promote prudent investing, while picking stocks, timing markets, and track-record investing tend to encourage speculative investing. Apart from the fact that fiduciaries of retirement plans--who are responsible for managing other people's money--should not be speculators, one of the big problems with active investing is that, in order to be successful, it requires fiduciaries to always be "right" in the sense of forecasting which investments will turn out to be winners (or losers) and outperform (or underperform). Fiduciaries, of course, cannot always be right when it comes to achieving superior investment performance. They must, however, always be prudent when it comes to their fiduciary conduct under ERISA.

I hope that my pontificating has been helpful to you and others who are charged with the tremendous responsibility of providing a prudent retirement plan for plan participants.

We have valued our association with you and your colleagues over the years, and wish you much luck in your professional and personal endeavors.

Best regards.

The author is a freelance contributor to Morningstar.com. The views expressed in this article may or may not reflect the views of Morningstar.