How to Select the Right Financial Products?

Stocks are down. Bonds are down. Market volatility is high. We’re all feeling a bit frustrated with our investments this year and wondering if we need to do a portfolio overhaul. This also includes deciding which financial instruments are the right ones for your personal situation.

According to Christine Benz, Morningstar’s director of personal finance and retirement planning, “It’s generally not a good idea to think of a major portfolio shift amid market volatility.” She wouldn’t recommend market movements as a catalyst for an investment decision, since emotion often drives it are in the game.

But if you decide this is the right time for you to make major portfolio changes, what should you do to ensure you’re selecting the right products? We have some ideas.

First, do your due diligence

Before you even think about what to buy, it’s important that you understand this why behind this decision. Here are four steps not to ignore:

  • Step 1: Look at your goal holistically.
  • Step 2: Determine your risk tolerance and then select the investment types that fit it.
  • Step 3: Commit to a schedule. This gives your money time to grow and multiply.
  • Step 4: Stick to your plan and just do your annual check-in or your quarterly check-in or whatever works best for you and your situation.

To understand why these steps are so important, let’s consider two diametrically opposed scenarios in which you need to make a decision about which financial instruments to buy.

Scenario 1: How to choose the right investments for short-term goals

Any time you’re saving for a short-term goal, it pays to spend a few moments turning your decision making into numbers. It will be helpful to answer a few questions about this, including:

  • Given your investment mix, how likely is it that you will achieve your financial goals?
  • How much have you saved so far?
  • How much additional contribution will you make per month?
  • How many years do you have to save and invest?
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Once you’ve answered these questions, finding the right investment mix also depends on your own risk capacity, risk appetite, flexibility in relation to your goal, and willingness to increase your own savings rate when it means more security in mind.

For those planning to buy a home within five years and not wanting to risk their investments being at rock bottom when the need arises, Benz says they can opt for a more conservative wealth mix, even if it makes it less likely that you’ll end up with significantly more than yours earn target amount. On the other hand, if you’re willing to push back your home purchase date if it gives you a chance at a larger down payment, you can adjust your asset allocation to be a bit more aggressive.

However, Benz suggests not overdoing it with stocks, since the portfolio should be more volatile than ideal in the short term.

When choosing investments for short-term goals, you can look for money market instruments and money market funds with attractive yields. When it comes to fixed-income securities, you have to keep in mind that long-term bonds are more affected by rising interest rates than short-term ones. Finally, “To the extent that you keep a portion of your short-term portfolio in stocks — and that’s optional, especially for conservative types — focus on high-quality large-cap funds,” says Benz.

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Scenario 2: Choosing the right investments for retirement

Getting a handle on how much you’ll need for retirement is one of the most common — and important — financial challenges faced by those of us who are still working. It’s a calculation involving many variables, some under your control, some not.

Some factors to consider are:

  • Your Income Replacement Rate
  • your retirement age
  • your life expectancy
  • your savings rate
  • Your payout rate (the percentage of your savings that you will need to use each year in retirement) and
  • What (if any) public pension could be in store for you?

“Retirement requires looking at whether the livelihood will last over the time horizon,” says Benz. And from there you can then look at the positioning of the portfolio and the selection of financial instruments.

An important consideration when choosing holdings for your portfolio is the volatility you are comfortable with.

If you’ve reacted poorly to market volatility over the past several years — for example, by selling out of positions when they were at a bottom — you should emphasize protection on the downside.

“The most important way to reduce your portfolio’s volatility is to adjust its asset allocation, but you can also reduce the ups and downs in your portfolio by focusing on investments that take a risk-aware approach to a particular asset class,” says Benz. “In assigning Morningstar Medal ratings, Morningstar analysts take into account funds’ attention to downside protection.”

If you know you can handle higher volatility when the prospect of higher returns comes with it, you should consider making your portfolio more aggressive and placing a greater emphasis on investments that have the potential for higher long-term returns, too if this is the case come with higher volatility.

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Don’t forget the fees that could eat up huge chunks of your pot

Finally, don’t forget to look at the cost, because high fees kill performance.

Morningstar research has shown that fees are a reliable predictor of future returns. Low-cost funds generally have a better chance of surviving and outperforming their more expensive peers. This is because fees add up over time and eat away at returns. Spending is also one of the easiest factors for mutual fund investors to control. You can’t be sure how a fund will perform, but you can know exactly how much you’re paying for it.

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