Target Date Funds and the Glide Path

Target date or lifestyle funds have quite different glide paths depending on the company. The glide path is how the fund moves from a 80-90% stock portion when there are still 20+ years to go to a much less aggressive stock position as the target date is reached.

As stated in a Journal of Financial Planning article by Bodie, Fullmer and Treussard (March 2010),  "...some glide paths seek only to manage TO the target date, while others go further - to manage THROUGH the target date, presumably for the rest of the investor's life..."

The stock portion of the target date fund could be in a range from 25% or less to as much as 70% or more by the time the target date arrives. The answer to which is better is impossible to answer as it depends on the individual's level of risk, income needs and other factors.

The important thing is to know how your target date or lifestyle fund is moving from aggressive to less aggressive. They mostly do but some studies have even shown that this general glide path direction may not be the right answer anyway. 

Asset Allocation Makes The Difference

In a May 2010 analysis of withdrawal rates by Craig L. Israelsen in financial-planning.com magazine,  the author found that over 16 25-year periods from 1970-1994, 1971-1995 etc...through 1985-2009 a 5% withdrawal rate, increased annually by 3% for inflation, and starting with $100,000 did not run out of money.

Of-course, there were many years in the first 13 of the 16 periods used that experienced inflation that was higher than 3%. This always begs the question of what your spending will really be like in retirement. It is a factor that we all can exercise some control.

Another aspect, is the bond/stock mix. As Israelsen states "...diversification should be a key attribute of every portfolio at every point in the life cycle...". A 100% bond portfolio did not keep up with inflation but never went to zero. A 60% bond and 40% stock portfolio performed better and the reverse, a 60% stock and 40% bond portfolio up to a 75% stock and 25% bond portfolio had even higher ending account balances and never went to zero during the 25-year period.

We cannot control inflation and the market conditions but we can control our asset allocation mix and our expenses. Manage what you can control. The "...multi-asset portfolio survived in all 16 rolling 25-year periods..." at a 5% withdrawal rate and even at a higher 8% withdrawal rate. 

These withdrawal rates (of 5% and 8%) are quite in this academic exercise but sometimes erring on the side of such a conservative withdrawal rate of 4% - which is just a rule-of-thumb anyway - could mean drastic changes to lifestyle in retirement.

The $100,000 portfolio during the 1975-1999 period increased over 25 years to more than $1.5 million (remember, though, that the inflation rate was fixed at 3% and was not the rate experienced during that 25-year period). However, during the 1984-2008 period the $100,000 balance ended at $400,000. 

It is true that when you begin to take withdrawals matters based on market conditions.

 

Dynamic Asset Allocation

Here are some highlights from James Picerno's 2010 book entitled Dynamic Asset Allocation - Modern Portfolio Theory Updated for the Smart Investor.

(1) Diversification is for managing risk, not nor managing returns

(2) Risk management should begin with the global market benchmark weighted by market values and then varying those weightings based on your personal goals and perceived risk.

Just to give you an idea of what the global market looks like:

In 2008, that global portfolio had 39% in stocks, 30% in government bonds and 22% in corporate bonds. The rest: REITS 4%, Tips 2%, High-yield 1%, commodities 1% and natural resources 1%.

(3) Improving the stock/fund selection process and then owning the best picks is the wrong approach.

(4) Business and economic cycles really do exist. An inverted-yield curve signals lower future expected returns and, in recessions, a steep, upward sloping yield curve signals higher future expected returns.

(5) Since 1857 (there have been 35 recessions). That is about one recession every 4-5 years. 

(6) When the economy is in recession, stocks go down pricing in the higher risk. More importantly, that perceived higher risk signals that future returns should be higher because higher returns are correlated with higher risks.

(7) Historical data suggests rebalancing a portfolio every 2 to 5 years.

(8) Small-cap Value companies make up slightly more than 7% of the U.S. market capitalization and are, indeed, a good diversifier for a portfolio.

Your Portfolio Allocation in Retirement

Maybe you have heard of the safe withdrawal rate "rule-of-thumb" that you can withdraw about 4% of your nest egg balance annually and have a reasonably good chance that you will not run out of money in 30 years.

There are many studies that evaluate whether 4% or 2.5% or 5.5% is the right number. If you can be flexible each year, then several percentages may work. But one thing that is key is how much of your portfolio is in stocks versus fixed income (bonds and/or cash, money markets, etc.).

Mr. Bengen began this analysis/discussion in 1994 and came up, in later years, with a "safemax" percentage where your money will last 30 years. The key is that you must have some portion in stocks.

40% is the likely minimum and 80% may be the maximum needed, but somewhere in this range is probably the amount of stocks needed to maintain a withdrawal that will be sustainable.

A February 2012 contribution in the Journal of Financial Planning by Sacks "...repeated all the calculations and analyses, but with a 70/30 asset allocation in the portfolio, and with an 80/20 asset allocation. The results were essentially the same. This finding is consistent with Bengen's observation that "for a wide range of stock allocations - between 40 percent and 70 percent - the safemax is virtually constant..."

Human Capital

Human capital is your ability to earn an income. When you are young, your investable assets are small but your potential to earn income is in the millions for most people.

It should affect your portfolio allocations.

In a November, 2013 Journal of Financial Planning article by Bridges, De'Armond and Dean they wrote: "...With financial assets comprising a small portion of the total portfolio in relation to human capital, researchers have concluded that most households can afford to take on higher risk in the their financial portfolios...(Lee and Hanna 1995; Gutter 2000; Ibbotson et al. 2007)...."

I agree that your income is another important part of the calculation of your overall asset allocation and must be considered. It is subject to risks and therefore disability and life insurance may be possible solutions to minimize that risk. Not investing too much in your employer's stock, if available to you, is another.

Whether your income is "bond-like" (stable) or "stock-like" (commission only or more uncertain) is yet another element to include in this strategy.

Rebalancing Thoughts

Regular rebalancing (for example, once or twice per year on the same date) may not be as advantageous as "opportunistic rebalancing" where you rebalance when your pre-determined allocation percentages change.

I recommend this type of rebalancing. For example, if you want 10% in small-company stocks and find that it is now at 12% (which is 20% higher than you wanted), then rebalance back to 10%.

Gobind Daryanani in a June 2009 FPA journal article by Carly Schulaka stated "...historically, I have found that using a 20 percent relative band maximizes your rebalancing..."

"...in a turbulent market, it's better to go with a larger relative band - say 25 or 30 percent..."

MPT - Modern Portfolio Theory

Modern Portfolio Theory (MPT) is a fancy term for developing an asset allocation strategy that combines different asset classes with low correlations with each other into an optimized combination of risk versus return. Since it was developed by Markowitz in 1952, some would say hardly "modern".

But it is modern and it does work. That is, over long time periods of regular and irregular distributions of investment returns and correlations it works. However, as Brian Dightman writes in the February 2010 issue of Financial Advisor magazine "...it fails miserably to model the frequency of extreme events over shorter time frames..."

So, be careful when you hear about new theories and strategies to manage your money. Over the long-term, asset allocation and diversification works. New theories abound these days but are mostly new market-timing strategies of one sort or another over short-term time frames.

Here are some that Mr. Dightman cites:

PMPT - Post-Modern Portfolio Theory (tries to identify that losses are worse than gains)
DPO - Dynamic Portfolio Theory (dynamic is just another word for market-timing)
GARCH - Generalized Auto-Regressive Conditional Heteroskedasticity (with univariate, bivariate and multi-variate steps in the optimization process)

Over the short-term, when markets plunge, all assets seem to go down together so the efforts made to have different assets with different correlations does not seem to work very well. But, keep in mind, that this is over a short period (meaning months to maybe 2-3 years).

Can individual investors really benefit from these so-called "sophisticated" strategies?

Rebalancing vs. Redirecting

If you are working and adding to your retirement funds, redirecting contributions to areas that are under your desired allocation is a good strategy. If you are retired, then rebalancing is the most effective method to maintain your desired allocations between asset classes (bonds/stocks/large companies vs. small, etc.)

When to rebalance? Studies have shown and, specifically research by Gobind Daryanana as reported in financial-planning.com magazine (December 2008 issue: "Balancing Acts"), shows that 20% relative bands are optimal. What?

Simple. Really. If you specify, for example, that you want 10% of your portfolio to be in small-company value stocks, then a 20% relative band means that if your small-company value funds are less than 8% (20% less of the 10% desired) then you would buy more and add to that category. If that style of fund is 12% (20% more than the 10% desired) or more of your total portfolio then you would sell some to bring it back in line.

If you are still working, then you would just redirect future contributions to the laggard funds.

How often does this happen? Some advisors will lead you to believe that you have to watch it daily or monthly at least but that does not seem to follow the actual data. You may find that every 3 years that your allocations may get that far out of line to require adjustments. You still should monitor more closely especially when market volatility is high (like these days).

Alternative Asset Allocation Mix

Pension funds have for years used a 60% equity and 40% fixed income portfolio to match assets to future liabilities (paying out retirement benefits). Financial-Planning.com magazine recently reported on a study of investment returns from 1970-2009 comparing a 60-40 mix with a revised 55-35-10 mix. That is, 55% equity and 35% bonds and 10% in those infamous alternative investments. In this case, 10% in the Goldman Sachs Commodity Index (GSCI).



Geometric annual returns averaged 10.24% for the conventional 60-40 portfolio and 10.17% for the 55-35-10 mix. The risk, however, to get there was considered a little bit less at 10.48% when including commodities and a higher 11.04% for the plain vanilla stock/bond portfolio.



So, it appears that adding commodities to the mix may be slightly beneficial (during that historical period) because the commodities returns often move differently than the financial asset classes of stocks and bonds. In other words, one zigs while one zags. The problem, of-course, is consistently staying invested in the proportions assigned and being true to the allocation of 55-35-10 rather than being mad and selling the fund that did not do as well as the others. In addition, during this crisis from 2007-2009, everything went down together so you must be prepared to hold on during difficult periods like we just experienced. Did you?



I have talked to so many advisors that during the October 2007 - December 2008 first leg of of the downturn and then the final January-March of 2009 disaster, did not rebalance. They did not buy into falling stocks to rebalance the portfolio.

If you don't, then these studies don't work because they are based on "...the removal of all emotion..." from the asset mix. In reality, that is the key - removing emotion from your asset mix.

You say that your advisor is beating the S&P?

Asset allocation determines more than 93% of the volatility of your return based on studies of the asset mix. Although volatility (ups and downs) may not equate directly to your actual return, they are correlated. More importantly, you have to understand these concepts of allocation and diversification. Your advisor, for example, has you in 80% US stocks and 20% International as an aggressive, long-term investor and he tells you that your portfolio is beating the S&P 500 by 2 percentage points.

If the US Stock market (as measured by the S&P 500) did, for example, 10% and you have 80% there, then that contributes (.80 times 10%) which equals to 8% of your return.

If International, on the other hand has done 20%, then that contributes (.20 times 20%) which equals to 4% of your return.

So...your total portfolio return is 12% and beats the S&P 500 by 2% - not by any miracle working stock-picking by your advisor but simply because of the asset allocation. Be careful to measure your total portfolio by the correct benchmark. In this case, you would compare your returns to 80% of the S&P 500 and 20% of your return to the MSCI EAFE index possibly. If, and I remind you that this is just an example, the S&P 500 index had done 10% and the MSCI EAFE had done 25%, then in reality, your portfolio under-performed.

Lesson: make sure you are comparing results against the proper benchmark and it almost universally is not going to be the S&P 500 if you have international and/or bonds in your mix.

Ric Edelman's Asset Allocation System

In Ric Edelman's new book, "The Lies About Money", he introduces a GPS - Guide to Portfolio Selection which is kind of neat.

Check it out: https://www.advisorlynx.com/secure/edelman/

You do not have to provide a name and address but only a zip code and an e-mail address and it is free. It is interesting but read and understand fully his required disclaimers.

I will write more about this in my book review, but some of the pie chart slices for what appear to be efforts at diversification have correlations of .90 or higher with other items in the asset category (meaning that the elements of the strategy move pretty much in lock step with each other). For example, intermediate government and corporate bond holdings are highly correlated so maybe there is a slight return difference but basically both categories are going up and down together. My opinion: "So what is the point? If you need fixed income, then choose one or two bond categories and be done with it."

Just a thought.

Fama/French 3 Factor Analysis

The 3-Factor model has been around for awhile now and you can learn more now from this website below. Good? Bad? Neither. Just a different approach that favors small-mid and value over growth as a philosophy. Is this right? Wrong? Well, it has been a good approach for the past 6+ years but no one approach works consistently over time and that is why diversification is so important. Also, no one knows when large company and growth companies will out-perform small-mid and value, though many analysts believe we may continue to see this happen as has already started (two years after analysts thought it would) - so much for market-timing:

http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

This website link will provide detailed information on how portfolios and fundamental indexes are designed for the DFA (Dimensional Fund Analysis) funds that are available only through advisors. The expense ratios for these types of funds are very low (like ETF's) but since you can only get them through an advisor, who may be charging you 1-1.5% per year on top of this, then it is hardly a bargain for anyone but the advisor.

Wisdom Tree is also using this approach with ETF's that you can purchase on your own. The key is to understand the asset allocation philosophy that you are following and to buy and hold to avoid the transaction costs.

Commodities versus simply understood CASH

This week I picked up a piece of research from the Global Investment Strategy team at the famous Swiss investment bank UBS AG. They were testing the assertion that commodities are a reasonable play against inflation. Here's what was reported:

"...Because commodity price returns are only weakly linked to stock and bond returns, it is assumed that commodity prices must provide a reasonable degree of diversification in a portfolio.

But UBS concludes that the emperor hiding behind this conventional wisdom simply has no clothes!

Their study shows that spot or current historic commodity prices have underperformed the consumer price index over the past 36 years by a cumulative 21%. Also, had an investor held interest-bearing cash throughout the period, he or she would have outperformed commodity prices by 46%.

UBS blames the returns on technological advances, which inevitably reduce the cost of production and depress commodity prices.

They also point to a sharp run-up in spot prices during the first few years of the 1970s and the last couple of years. They claim that this completely accounts for the strong performance of the Goldman Sachs Commodity Index for the 36-year period under review.

Basically, had it not been for these two periods of strong performance, commodities wouldn't have turned up on investors' radar screens..."

So, cash has a very low correlation with stocks and bonds though it does not have the higher "expected return" of other asset classes like commodities, real estate or natural resources. But then again, it is a good diversifier for the stock investor and those "expected returns" of commodities and other alternative categories are short-term expectations. Over the long-haul (and we are long-term investors, right?), you may find that the speculation is not worth the effortless comparison of investing some of your money simply in cash (CD's, money markets for example) where no market-timing is needed.