Human Interest focuses on diversification, asset allocation, and low fees when designing an investment lineup for retirement plans
The trick is balancing risk and reward to get the highest return potential for an acceptable level of risk
We try to achieve that balance through passive investing strategies that evaluate each investment’s diversification characteristics
Human Interest’s investment philosophy is grounded in Modern Portfolio Theory, which seeks to maximize the possible reward for a given level of risk. That’s why we aim to design an investment lineup for plans that focuses on diversification, asset allocation, and low fees.
What is Modern Portfolio Theory?
Developed in 1952, Modern Portfolio Theory remains a popular model in shaping retirement portfolio design. As Forbes notes, it’s a key tool for both asset managers and automated portfolio design. Modern Portfolio Theory seeks to maximize the expected return for a given amount of risk. It assumes the average investor is risk averse and will choose the less risky portfolio when presented with portfolios with similar expected return potential.
There's an expectation that riskier investments carry higher return potential. If you invest in what’s generally considered a lower-risk option—for example, bonds—it may generate lower returns. And higher-risk investments can, but may not, result in higher returns. Separately, putting money away in a savings account can, over time, lead to a reduction in purchasing power, as such accounts offer no protection from inflation. (A dollar you put in a savings account in 2022 wouldn't likely be able to buy a dollar’s worth of goods in 2050, if the account’s interest rate does not keep up with inflation.)
So, the trick is balancing risk and reward to get the highest return potential for an acceptable level of risk. In this article, we’ll look at how we try to achieve that balance through passive investing strategies where we evaluate each investment’s historical diversification characteristics. And we’ll review the importance of being aware of how to identify “acceptable risk” while being mindful of the concepts of Modern Portfolio Theory.
Types of risk
There are two types of risk: systemic risk and asset-specific risk.
Systemic risks broadly affect the market and include risks posed by economic downturns, wars, interest rates, and so forth. This is the risk people assume when they invest anywhere and everywhere in the system of the global financial market.
Asset-specific risk is the risk attributable to what happens within the company, government, or other entity that issues the asset—not the world generally.
The three basic asset categories are cash, equities, and fixed income. For more information on asset types, see our article about asset allocation.
Diversification and correlation
For most investors, there’s not much to be done to influence systemic risk. Modern Portfolio Theory does, however, offer a guide for mitigating asset-specific risk, through diversification*. Diversifying investments is the practice of not putting all your eggs in one basket, instead investing in assets that may respond differently to changes in the market.
A central tenet of portfolio diversification, correlation is a statistical measurement that compares how two securities move in relation to each other. For example, when a stock and a bond—or stocks in different industries—move in different directions, they are said to be negatively correlated. Correlation is measured by a coefficient that ranges between -1.0 and 1.0 that attempts to quantify the relationship between two securities.
If securities move in similar directions, they’re most likely considered to be correlated. A perfect positive correlation implies that securities mirror each other and a coefficient of 1.
If securities move in opposite directions, they’re most likely considered to be negatively correlated. A perfect negative correlation has a coefficient of -1.0 and implies that two securities move in opposite directions.
Finally, a zero correlation implies no relationship (or an independent correlation).
Modern Portfolio Theory argues that investors shouldn’t consider the assets in a portfolio in isolation; rather they must be considered as they relate to each other, “both in terms of potential return and the level of risk each asset carries.”
Gaining a holistic view of your portfolio's investments can help mitigate the effect of a particular asset by spreading investments across different types of asset classes. This can be done by considering how each security’s risk and rewards fit into the portfolio's overall risk and reward profile. For example, stocks, bonds, and other securities may have different relationships with each other. And if one investment in a portfolio performs badly, then assets that have been negatively correlated with it could do well, which may reduce your overall portfolio risk.
Index funds—either mutual funds or ETFs—group assets in an attempt to track a financial market index, such as the Standard & Poor’s 500 (S&P 500). For example, an index fund that “tracks” the S&P 500 may hold shares in the companies listed on that index. By tracking a market index, an index fund can provide broad market exposure and generally low operating expenses—or low fees—another advantage of index funds. One example, Vanguard 500 Index Admiral (VFIAX), an index mutual fund, tracks the market-cap-weighted S&P 500 so that investors are exposed to U.S. large-cap stocks**.
*Diversification does not assure a profit or protect against loss.
**This should not be construed as a recommendation to buy or sell any investment. Consult a financial professional regarding your personal situation before making any investment decisions.
Modern Portfolio Theory takes a passive approach to investing. Passive investing encourages a buy-and-hold strategy, meaning that investors hang on to their investments over the long haul, regardless of market conditions. Index funds, for example, seek to follow their benchmark index regardless of the state of the markets. Even in given periods of market volatility, the general trend is that the longer you hold investments in the stock market, the more potential for them to grow.
Passive investing stands in contrast to active investing. Essentially, active management means professionals are trying to “outperform the market,” by buying and selling assets according to how they believe they will perform compared to the broader market. Over time, passively managed funds may do better than actively managed funds for a variety of reasons, including the fact that trying to predict the financial market is notoriously difficult, even for investment professionals. Additionally, active managers tend to have more portfolio activity, which could result in more purchases and sales which could increase fees. Conversely, passive index funds typically offer investors lower fees so you can keep more of your investment.
Whatever the make-up of your portfolio, you should consider portfolio rebalancing, which is designed to help bring a portfolio back to the desired asset allocation. Different investment types react differently to the market, which can cause your portfolio to fluctuate.
For example, let’s say you start with a 60% equity and 40% fixed-income portfolio. If your fixed income investments do well, at the end of the year, your portfolio allocation may have 50% equities and 50% fixed-income. If 60/40 remains the appropriate allocation for your portfolio, you’d want to rebalance to maintain that ratio, because it’s your acceptable level of risk. In other words, rebalancing holdings can help bring your portfolio back into its desired mix of asset types.
What is “acceptable risk”?
Risk tolerance refers to an individual's ability—and willingness—to tolerate the ups and downs of the market in exchange for greater potential returns. Determining or choosing an asset allocation should depend, in part, on the individual investor’s sense of acceptable risk. This depends on both an investor’s general level of comfort with the possibility of losing money in investments, and how able they are to accept that risk given their individual circumstances.
It’s generally recommended that the closer investors are to retirement, the fewer risky investments they should hold—as they’ll start withdrawing from that account in the near term. For someone at the beginning of their career, however, that can be less of a concern—they’re not likely to need the money in their retirement plan for several decades.
Human Interest's platform provides a risk questionnaire that plan participants can use to help them determine their risk tolerance and adjust or choose the appropriate model portfolio allocation.
What are target-date funds?
Target-date funds (also known as lifecycle funds) are mutual funds designed to offer decreased risk as time passes. This is typically done by reducing the investment in stocks and increasing the investment in fixed-income as the investor nears the “target date” (the expected date of retirement). In 2019, 54% of 401(k) participants in their twenties were investing in target-date funds, according to the Employee Benefit Research Institute. Despite their popularity, many target date funds are actively managed, meaning their fees can be higher than other index funds. According to a Morningstar report from 2022, investors, on average, have paid an asset-weighted fee of 0.34% for target-date funds (based on data from 12/31/21). That's more than $30 spent per year on management for every $10,000 invested.
Asset allocations for target-date funds can also vary widely—despite having the same target dates. For example, a 2050 target date fund that’s right for one person retiring in 2050 might not be right for another person planning to retire in the same year. This can make it difficult for investors to understand what they’re investing in and puts the onus on the individual to review the target date fund's prospectus and investment glide path. Target date funds generally only consider a participant's age and targeted retirement date—and do not consider an individual's circumstances, which can vary widely person-to-person.
Plan sponsors should be aware of investment fees, as these can quickly add up for participants. In contrast, 401(k) providers who offer automated portfolio design may offer access to low-cost mutual funds. A managed account option in a Plan may also consider an employee’s risk tolerance and life expectancy. For more information, read about our position on target funds.
Socially responsible investing & ESG funds
More and more investors are starting to think whether their money is invested somewhere they can feel good about (or at least not feel bad about). Globally, the money invested in environmental, social, and governance-focused (ESG) funds rose 53% from 2020 to 2021. ESG investing* may include the consideration of company management practices as they pertain to sustainability and community improvement and how those management practices affect a company’s bottom line—rather than simply what a company professes to value or what products it sells.
Socially responsible investing can strike a balance between traditional investing—which focuses on accumulating funds—and donating money, which offers social impact, but does not offer the opportunity to invest, balancing risk, return potential, and impact. In the 1980s, for example, investment funds began divesting from South Africa, to protest the system of apartheid. In recent years, concerns about gun violence and climate change have spurred investors to look for assets that don't appear to contribute to these issues. This allows individuals to not only invest in the market, but also in causes important to them.
Because regulations determining what qualifies as an ESG investment are still being developed, it’s important that investors know their goals for investing in an ESG fund, as well as what investments a particular fund holds, to make sure they’re making the investment they think they are. Human Interest can offer the flexibility to Plan Sponsors to include ESG funds in plan investment lineups that align with our focus on diversification and low-cost investing requirements.
*ESG investments may limit exposure to certain companies and sectors which may mean forgoing investment opportunities available to investments without similar constraints. There is no guarantee that an ESG investment or the incorporation of ESG considerations will lead to stronger performance.
Human Interest’s investment lineup
Following Modern Portfolio Theory, Human Interest focuses on designing a plan investment menu and model allocations that consider risk tolerance, diversification, and mitigating expenses with low-cost funds. Human Interest’s open-architecture investment platform provides access to mutual funds in every major asset class.
This breadth of options allows us to serve all kinds of Plan Sponsors—no matter the needs of their participants. Participants seeking more flexibility can even choose and manage their own lineup from available funds from the Plan’s investment menu. Of course, there are a lot of moving parts to consider when you’re looking to start or maintain a retirement plan for your employees (even if that’s just you!). But Human Interest can help you determine what kind of retirement plan could work best for your business and its employees.
Take a look at our investment philosophy or get in touch with a Human Interest team member to learn more.
Investing involves risk and may result in loss. Indices are unmanaged; you cannot invest in an index. Past performance does not guarantee future results. This content has been prepared for general informational purposes only and should not be construed as individualized investment advice. Consult an appropriate professional regarding your personal situation before making any investment decision. Human Interest does not provide tax or legal advice. Data and statistics contained in this article are obtained from sources we believe to be reliable, however, we cannot guarantee their accuracy or completeness. The views expressed in this article are subject to change.
Human Interest's Program is available to the Plan/Plan Sponsor only. Investment advisory services provided by Human Interest Advisors is limited to Plan investments and such services and/or duties specifically delegated under the terms of service. Read more for additional details.
*Amy Johnson is an independent contractor commissioned by Human Interest to help contribute to this article.
Article ByEric Phillips, CFA
Eric Phillips, CFA, has dedicated his career to improving financial wellness. He began his career at Artisan Partners, a global asset management, firm and currently serves as the Senior Director of Financial Partnerships at Human Interest where he works with financial advisors and industry partners to help them offer affordable retirement plans.