Do a Google search on Millennial investors and you’ll find a fairly cookie-cutter assortment of results. They’re making huge mistakes. They’re never going to have enough saved for retirement. Their fate is certain doom. Woe is Millennial.
Now compare that web of critique with the reality of what Millennial investors are dealing with in their financial lives. Almost half (48%) of Millennials say they live paycheck to paycheck, and 44% feel like they’re not in a good financial position, according to the 2016 Wells Fargo Millennial Study. What’s behind this financial instability? For starters, consider the 34% of Millennials who carry student debt: 71% say it’s holding them back from saving for retirement. Overall, Pew Research suggests Millennials are the first in the modern era to have lower levels of wealth and personal income than the two previous generations had at the same age.
Let’s show a little empathy, internet! It’s no wonder 43% of Millennials identify themselves as conservative investors, according to Accenture. Millennials want to avoid volatility because they equate it with losing money—and they have no leeway to lose money.
To the risk-minded Millennial, it might seem like sidestepping volatility altogether is a conservative strategy. After all, if you never invest in a stock, you’ll never have to watch in horror as its value fluctuates. However, concentrating one’s savings in a narrow mix of conservative investments such as bonds is not, in fact, a conservative approach.
Consider the following graph, which compares how a portfolio comprising 70% stocks and 30% bonds would have performed versus a portfolio comprising 100% bonds over the past 30 years.
What’s happening behind the scenes in these two portfolios is more than just one asset class outperforming the other. There’s something much more scientific happening, and it’s something every risk-minded investor has the power to influence: correlation.
If a Millennial investor were to build a portfolio containing mostly, say, investment-grade bonds, with the goal of avoiding volatility, an unintended effect could happen. Together, the bond holdings would be highly correlated, so if a major economic event affected the bond market (like the Federal Reserve raising interest rates), all of those holdings might move in lockstep—potentially downward. So, in this case, the conservative investor would end up having taken more risk than he or she had planned for.
So what might Millennials consider?
- Millennials could consider broadening their view of volatility to the entire portfolio, not just a specific investment.
A highly correlated portfolio introduces more volatility. But Millennials should also note that an all-bond portfolio isn’t compensated for that volatility in terms of added potential returns. Bonds have typically offered a lower rate of return than stocks. An overly conservative portfolio could result in modest returns that cannot offset losses over time. Constructing a portfolio based on the view that one type of investment is safe—and therefore should comprise the entire portfolio—may be riskier than imagined.
- Millennials could consider expanding their focus on volatility from risk to its counterpart: expected returns.
Stocks and bonds have varying degrees of frequency and severity, in terms of providing expected and unexpected results for investors. This can lead to a stock being highly volatile with recurring downswings. Risk-minded Millennials should remember that volatility also swings high, sometimes resulting in gains that can grow a portfolio’s value. Moreover, it’s important to take the long view in evaluating an investment’s volatility rather than watch its daily ups and downs. Investors can do this by calculating an investment’s variation, or the differences between its returns on a year-versus-year basis. Investors can also gauge volatility by calculating an investment’s standard deviation from its average annual returns.
- Rather than avoid volatility completely, Millennials could consider managing volatility through portfolio diversification.
Avoiding the stock market’s volatility means potentially leaving money on the table. But that doesn’t mean Millennials should shift their stock/bond ratio to 100% equities. Stocks can also have high correlation. For example, a portfolio comprising only energy stocks could swing too low to recover in a year marked by falling oil prices. Millennials can avoid this fate by diversifying across a wide range of investments—based on their issuers’ size, industry, geography, and expected volatility and returns, among other characteristics.
So how should Millennials construct their portfolios? This is where asset allocation comes into play, or the concept of structuring and continuously rebalancing one’s investment portfolio at various stages in life by using different types of investments.
But remember, there is no magic, one-size-fits-all asset allocation that all Millennials should follow. While it’s true that Millennials may be part of one big generation comprising millions, they are individuals, after all. Therefore, it’s important that they build their portfolios based on their own unique financial situations, risk tolerances, and goals for life during work and retirement.
For more insights on the investing topics discussed in this piece, investors can check out the following blog posts:
- Expecting volatility in 2017? A case for diversifying
- Millennials: A financial mindset shaped by recession
- How to squeeze more retirement savings into your budget