Paul Winkler: Welcome. This is “The Investor Coaching Show,” and I am Paul Winkler, talking about money and investing, educating as we go, and just plain having some fun.
One of the things that has been a topic in the past couple of weeks is the automatic type of options that you have in 401(k)s.
Typically, you go to your employer, and the employer says, “Okay. We have enrolled you”—and this is more and more how it’s happening—”we automatically have enrolled you in the 401(k) at the company, and you can opt out. You can go and stop your contributions.”
But most people, they don’t take action. Inertia takes over.
And the reality is we typically don’t like to take action because of laziness or whatever, and like, “Yeah, I guess I should be saving money for retirement, so I’m not going to take action to opt out of the plan you’ve opted me in.”
“Okay. Great. Now you can change your investment alternatives.”
A lot of people don’t do that. Don’t bother.
It’s like, “Well, yeah, I don’t know what to change to. What do you got me?”
They’ve got a default one based on your age. They may do that.
Target-Date Funds and 401(k)s
Sometimes they’ll put you in a cash-type of account, but usually not. Usually, they’re going to put you in a target-date fund as your default option.
And then you can go and change, and they’ll give you other options like, “You can buy this large-cap fund, you can buy this small-cap fund, you can buy this commodities fund, you can buy whatever.” You can shoot yourself in the foot all kinds of different ways with 401(k)s plans.
Target-date funds typically are the … that’s the default position.
Now, one of the things that we’ve been seeing lately, finally—and I’ve been talking about this for 20 years and saying, “This is a problem. This is not good. These things are not great.”
You’ll have robo-portfolios, robotic portfolios. This is a big thing now.
I’ve had people, financial advisors, go, “Oh, Paul, what do you think of robotic portfolios? Oh, my goodness. This is something that we should be …”
I go, “No, we’ve had robotic portfolios forever.”
They’re like, “What?”
I say, “Yeah. They’re basically target-date funds.”
Robotic portfolios are where a robot’s choosing investment, and they can be run in different ways. Some can be downright dangerous where they’re stock picking and market timing and doing all of that.
In general, a robot, you look at it and they just set up an allocation based on your age. And they try to use some algorithms, which sounds really, really cool to a young person that, “Oh, wow. Algorithms. Wow. This is really great.”
Well, yeah, you know what? It’s basically a computer program by a person doing the same things that people have always done.
You’re just following the same flawed formulas and disjointed investment strategies.
The Flaws of Target-Date Funds
The question keeps coming up: Are target-date funds flawed?
I’ve often said, “Yeah. I’m not a big fan of them.”
There’s a new study that was talked about in The Wall Street Journal, and I actually talked about it here on the show, but it bears repeating because now Morningstar’s picked up on it.
They said, “An academic paper called ‘Simple Allocation Rules and Optimal Portfolio Choice Over the Lifecycle,’ by Victor Duarte, Julia Fonseca, Aaron Goodman and Jonathan Parker (the first two authors affiliated with the University of Illinois, the second two with MIT), recently attracted the attention of The Wall Street Journal.”
“Why Target-Date Funds Might Be Inappropriate for Most Investors.” It was Mark Hulbert writing that from The Wall Street Journal.
He has three main points that he summarized in the article.
Number one: “Target-date funds are well-suited for young investors.
“On average, target-date funds held by employees in their 30s hold 89% of their assets in equities.” And stocks. Okay? “That figure mirrors the authors’ estimates.”
Now, I would disagree with that figure.
Now, number one, it’s not just equities.
When you talk about investing, don’t just talk about equities.
Don’t just talk about stocks versus bonds. You got to look at it and go, “Wait a minute. There is a lot of academic research that says we got to go beyond ‘This holds stocks, this holds bonds.’”
What kind of stocks?
What areas of the market? Which asset classes?
Are they big companies? Are they small companies?
Are they companies with a low price-to-book? Are they companies with a high price-to-book?
Are they companies that are domestically located? Are they companies that are in Germany and in France and Australia and Japan?
How about companies that are in Singapore? So on and so forth.
You got to look a lot deeper than that, number one. I think it’s the desire to oversimplify that, quite frankly, hurts investors, as I’ll get into more in a second.
Why Target-Date Funds May Not Work for Older Investors
“For older investors, target-date funds are too conservative,” they said in the study.
They said that “target-date 2035 funds, which address 50-year-old investors”—assuming that they’re going to retire in about 15 years, 2035, so 13 years, I guess it would be now, so they would be retiring in their mid-60s in other words—are invested 68% in stocks.
“When target-date funds reach their final date”—which is when you’re retired, purportedly—”which presumably occurs when the shareholders reach age 65”—that’s what they said in the article here—“they hold an average stock position of 40%.”
Now, “The authors prefer allocations of 80% and 60% respectively.”
Eighty percent when you’re, like, 50 years old and then 60% when you are at your retirement age. I wouldn’t generally disagree with that.
I would agree, generally, those are fairly decent numbers. More about that in a second, but in general, that’s not a bad rule of thumb so to speak.
“The needs of older investors vary more.” This is the third thing that they found in the study, that “the needs of older investors vary more than those of younger investors.”
That is generally true.
How Diversification Looks for Younger Investors
I often talk about how, as an investor, when I’m young, it is much more important for me to diversify in terms of my skills, my talents, my education, and the way I make an income.
And the things that I am doing to make myself more valuable in the marketplace are far more important. So making sure that you constantly stay up and abreast of the most recent information in your industry, or maybe even other industries.
I mean, good grief, your industry may be obsolete in 10–15 years, and maybe you ought to be learning something from a totally different industry in order to make sure that you’re still employable 10 to 15 years from now.
So that’s really important.
Now, diversification in your investments, and when they talk about diversification—and here, really, what they’re talking about: stocks versus bonds.
Because remember, they’re not even delineating between different areas of stock markets. They’re talking about diversification between stocks and bonds.
Now, stocks and bond diversification is not as important when you’re younger, because we’re not as worried about market fluctuations as we are the fact that inflation is destroying the purchasing power of your money.
Things that cost $3,000 in the 1970s, as I like to say, like a car, are now $30,000, $40,000, $50,000.
Why Do Older Investors Have More Varied Needs?
Okay. What happens here is they’re saying—in general—older investors, their needs vary more. And because the reality of it is you have some older investors that are pretty flushed.
They’ve done a pretty good job of accumulating money, and they don’t have the need to withdraw as much money from their investment portfolios as a younger investor. You’re in your 60s or 70s, and you’re only pulling 1–2% off of your portfolio.
Historically, you can afford to put more money in stocks than the person that is maybe really cranking it out and pulling 4–5% of your portfolio and you’re more worried.
Or maybe that you’re running your portfolio down on purpose. Maybe you’re actually drawing down some in retirement.
You’re 65 years old, and you’re going to go, “I’m going to take Social Security at 70. I’ve got this big bunch of money. What I’m going to do is—”
I got a million dollars, let’s say. What I’m going to do is I’m going to take $200,000 of it.
I’m going to spend that $200,000 down over the next five years in lieu of taking Social Security. Then I’m going to live off of whatever the $800,000 has hopefully grown to over the next five years, and that’s what I’m going to live off of.
The reality of it is that my withdrawal rate is very, very high. It’s 100% withdrawal of that $200,000.
You can see where you go, “Oh, because I’m withdrawing that money, that 200 grand, I’m withdrawing it over the next five years, I better stay super, super conservative with it. I can’t take risks with it.”
That’s an example of what they’re talking about, how “the needs of older investors may vary significantly from younger investors.”
Should Younger Investors Take More Risks?
Now, it says that “The first point is straightforward. [For] most younger investors, investment advice for retirement savings is blessedly simple,” they say.
“Save as much as reasonably possible, while placing those monies in higher-risk, higher-reward investments.”
Now, “Whether the investments should include fashionable assets like cryptocurrencies [and] NFTs”—non-fungible tokens—“can be debated, but [as] those can’t be owned by mutual funds, the question is moot. Long-dated target-date funds should invest largely in equities.”
Now, I wouldn’t say it’s debatable that you ought to be investing in those other things.
An investment is something where somebody’s using your money, and they’re paying you to use your money. By definition—by academic definition, anyway—that wouldn’t be an investment, a non-fungible token or a cryptocurrency, because it’s a commodity.
The investment industry has been falling over themselves for the past 10–15 years, jumping into commodities investing after commodities jumped in value because we had that big scare in 2008.
“Oh, my goodness, the world’s falling apart.”
I’m like, “No, this kind of stuff happens.”
Then when the investment industry started jumping into it, I’d shake my head and go, “Oh, my goodness.”
Like Fidelity: Their target 2040 fund literally had the top holding where the most money was in a commodities fund. I would shake my head and go, “What are they doing? Now, that’s not even an investment.”
Of course, over the next several years, that thing just crashed. I mean, horrible, horrible performance.
The investors in the fund, they’re the ones that took it on the chin. It was just literally that the investment industry kind of lost their way as they so often do.
So when we talk about risk: “They can go and take risks.”
Well, I look at it and go, “A lot of times, younger people are taking uncompensated risks.”
They’re taking risks for which there is no payment. You don’t want to go into individual stocks, for example.
A single stock or a handful of stocks, those companies don’t want to pay any more to use your money than they have to. So the expected return of holding one company, one large U.S. stock, is basically the same as holding the entire market, except that the risk is infinitely higher.
Why would we do it?
Well, because we think that it’s mispriced. It’s selling for a lower price than what it’s really worth.
“Shh, I know things about this company, and when it goes to its real rightful value, I’ll sell, and that’s how you make money.”
And it’s a myth, but people believe in myths all the time. That’s one thing.
Portfolio Managers Often Stick With Conventional Wisdom
It says, “Such has been the traditional wisdom. Portfolio managers rarely do anything different.”
I’ve often said that. What they do is they basically follow each other.
It’s like going 80 miles per hour, or 75 miles per hour, let’s use that as an example, in a 70-mile-per-hour zone. If everybody’s doing it, your chances of getting pulled over and getting called on it are pretty slim.
The same thing: if everybody’s screwing up the way they’re managing portfolios, the investment industry, nobody’s going to get called on it.
Anyway, so it says, “The authors do diverge from customary practice by contending that some young investors should place as little as 30% of their retirement assets into stocks.
“What makes those workers outliers”—because that’s what the study said, that maybe some people, younger people, should have only 30% in stocks—“What makes those workers outliers, and why they should invest more cautiously than their peers, is unclear.”
This is my explanation. Not that the writer of this article is listening.
But the reason is that some people have their positions, and their work is highly dependent upon the economy. And literally, if you have an economy that goes downhill, and the stock market goes downhill, they may need access to money sooner.
They may have a job that happens to be very, very dependent upon stock markets. Literally, their livelihoods and the stock market can be correlated.
That would probably be the only reason. But for the most part, yes, a younger investor ought to be less invested in bonds and a lot more in equity stocks typically. Okay.
“But their advice to the average younger employee is mainstream.” Which is hold more stocks, right?
Why Do Financial Advisors Typically Have Older Clients?
Now, “Neither is the third argument surprising,” they say.
“A corollary of the axiom that all younger investors are alike is that older investors are not. Their wealth and spending requirements differ greatly, as do their medical conditions and their life expectancies.”
They said this is—and this is one I want to kind of land on for a second. This is interesting.
Says, “The reason that financial advisors have mostly older clients is not solely because seniors are wealthier. It is [also] because their financial lives are more complicated.”
Now, I am going to disagree with this. The reason I disagree with it is because think about when you’re younger:
You got a lot of stuff going on. You’re trying to pick your auto insurance, your homeowner’s insurance.
You’re trying to figure out liability coverage. You’re trying to figure out what kind of life insurance to get.
You’re trying to figure out what provisions in a disability policy to have. You’re trying to figure out, how do you save for a kid’s college education?
What vehicles do you save into? Do you go pre-tax?
Do you go post-tax with your investments? IRA, Roth IRA?
Do you set up non-qualified accounts for anything?
Where do you purchase this house? How much do you put down?
What kind of mortgage to get? It’s just …
Wills. I mean, good grief, estate planning.
Who’s going to be the guardian for the kids? Who’s going to be the executor or executrix on the estate?
You have a lot of things going on that you have to make decisions on.
I don’t think it’s …
Yeah, seniors, it’s just different with seniors. I mean, when you’re senior, you’re looking at, okay, Medicare, do I use a supplement? Do I use an Advantage plan?
Social Security: When do I take that? How do I take that?
Which order do I take assets from for retirement income?
Yeah, there are complexities. No question, tons of them.
A lot more than most people give credit for.
What asset allocations should I have? How much in large companies, small companies, value companies, growth companies, international, U.S., and fixed-income?
What type of fixed-income investments, and how do you take the income? Do I do Roth IRA conversions?
All kinds of things that are complexities. But the reality of it is, to say that younger investors don’t have complex lives, I would disagree with that.
It’s just that the complexities are different. Why is it that younger investors typically—
And I was talking about this in the office. Michael and I were having a conversation, and he says, “Well, I think that a lot of times younger people just don’t think a financial advisor would be interested in them.”
I go, “Yeah. That would be true.”
Many times, financial advisors, because they’re selling products, they’ll have: “You got to have $250,000 to work with us. You have to have a million dollars to work with us.”
Because you’re not a big enough cheese in order to attract their attention, and they can’t make anything off of you selling commission-based investments. So yeah, that can often be the case.
Older Clients Have Figured Out There’s More to Know
But I think that there’s something else to it as well. The other aspect is bravado, I think.
When I talk about bravado, a lot of times what happens is that younger people, often, they’ll read, and they’ll study, and they think they’ve got something.
I’ve talked about this as the Dunning-Kruger effect before. Whereas you start to learn a little bit about something, and you feel like, “I got this. I got this.”
Then what happens is as you learn more, you realize, “I don’t got this.”
So often what happens with younger people is you think you really got it. It’s interesting.
My career, I went through this. I was a young financial advisor learning a few things, and in my first 5–10 years—good grief, yeah, 10 years really—of being in the business, I really thought I had it.
I really thought I’d got … and then all of a sudden I started getting introduced to academics and investing, going, “Whoa, I don’t got this.”
It’s amazing how much you realize you don’t know when all of a sudden it starts to get a little complex.
So that to me is one of the things. And what I find quite often is that we start to get calls, and I start to get … our client base is typically 50s plus.
It’s normally because they’ve hit their head against the wall so many times, and they’ve done it wrong so many times, that what they end up doing is getting a good dose of learning by their own mistakes.
I would rather somebody learn by somebody else’s mistakes, but that’s just life. I mean, we do that.
We bang our head against the wall. We make mistakes.
We make mistakes, and we grow. A lot of times people don’t get to the point where they go, “You know what? There’s more to this than meets the eye,” until they’re in their 50s and 60s.
Are Target-Date Funds Right for Younger Investors?
Let me go back just a second to a point in this article that actually talks about the asset mixes in younger investors versus older investors. I kind of skimmed over this at first, but I probably ought to reiterate it.
It said, “Target-date funds are well-suited for young investors. On average, target-date funds held by employees” in their 30s, 89% of the assets are in stocks and equities.
And I said you need to delineate more. Not just stocks versus bonds, but what kind of stocks is really, really important.
If you don’t really understand what I was talking about there—
Like I said, you got large companies, you got small companies, you got value, you got international, you got U.S. There are a lot of different areas in the market.
During different economic cycles, different types of companies do well.
When you’re a really, really big company—economies of scale—you’re really, really big, you can outperform everybody else because you buy in bulk and things like that. Smaller companies can move in technology much more rapidly.
Value companies don’t go down as much during market downturns. International companies tend to do better when the dollar’s weakening versus other currencies and so on and so forth.
This is an example I’ve given. If you look at, for example, Vanguard.
They have that new fund that they came out with a few weeks ago, the 2070 Fund.
If you’re retiring in the year 20—it seems insane, doesn’t it?—2070, you’re retiring in that year, then they’re going to put somewhere like 57%, as I recall, of your money is going to be in their total U.S. stock market portfolio.
Then 40%—or 33%, excuse me, is going to be in international total stock market portfolio. Then 10% in bonds.
So 90% in stocks, 10% in bonds. And the point that I made a couple of weeks ago was that you think that’s great because you own the entire total U.S. stock market, but you really aren’t that well diversified.
They’re using what’s called the CRSP 1–10. It stands for Center for Research in Security Prices 1–10 Index.
That’s what they’re mirroring with their total U.S. stock market portfolio. The CRSP 1 is the 10% largest companies in the United States, and then CRSP 10 is the 10% smallest companies in general in the U.S.
The example that I gave using their allocation, I went back and actually took the CRSP 1–10 index, and then I took an international—Europe, Australia, Far East: international—and then I did 10% bonds.
How Do Target-Date Funds Perform?
I said, “Okay. If you took a dollar, what would it have grown to using that allocation?” The answer was $161.
You go, “Oh, that’s good, $161.” Minus expenses, but that’s minuscule.
$161, that’s great. It’s phenomenal. That’s great growth.
Until you get that if you actually diversified between large U.S. companies as measured by the S&P 500, small as measured by the CRSP 9–10 (20% smallest companies), and the Fama/French U.S. value index, and the Fama/French U.S. small-value index, and then the Europe, Australia, Far East in the international side, and I used dimensional small index for small international stocks …
You look at that and say, “Well, if I was not even scientific about this, I just spread the money between those six and was done with it, what did it grow to?”
Well, $510. More than triple the amount of money over that period of time.
You go, “Well, wait a minute, so younger investors—it’s well-suited for younger investors?”
I would go, “Well, maybe well-suited for younger investors that don’t need a lot of money, or they don’t care that they have missed out on huge returns because they didn’t follow the rules of investing, which are: diversify.”
Now, I wanted to own Microsoft before it became Microsoft, when it was a small company. I wanted to own Chrysler before it got turned around as a company and it was a distressed, terrible value company.
Or any number of value companies out there that if you look back and see how the change in the price occurred when the companies were turned around, and that’s what you want to own.
You want value companies. You want to own companies before those changes happen.
It’s a big deal.
And then if you look at the difference between those two, it’s like I said, it was triple in my example here.
Now, the S&P 500, if I just put it in there, a dollar grew to $224. You look at that go, “Oh my goodness.”
Owning the lowest performing area of the U.S. stock market did better than what they’re doing, which is mind-boggling when you think about it, that they’re being hired to put together an investment portfolio that doesn’t do any better from 1970 until now.
Then what if you didn’t diversify, and you own just large U.S. companies? I mean, that’s pretty pathetic.
The Risks of No Returns
The problem is, why wouldn’t you want to just do the S&P 500? It’s a huge risk because you can go 10–20 years.
Well, we had 1966 to 1982 and then year 2000 through about 2013 where there was no return. I mean, that’s a long time to go without return, so a huge risk.
The point being is, risk doesn’t matter to a younger person, right? No.
Guess what? If you’re going 10–15 years with no returns as a younger investor, you’re panicking.
You’re freaking out, and you’re going to go do something. And you’re going to sabotage the portfolio.
So risk does matter, even to a younger investor. It really does matter.
Because you’ve got to look at how people respond to going long periods of time with no return. They don’t respond well.
Alternatives to Target-Date Funds
So if you look back at this article, they say, okay, “Are Target-Date Funds Flawed?” Yes, in many ways they are flawed.
What do we do? Well, in your workplace plan, you’re going to have a lot of other funds to choose from.
You’re going to be able to set up something, and that’s really a function of going, okay, what’s my time horizon? How long before I’m going to retire?
What do we have access to? What do we got for small-company funds?
What do we have for large-company funds? What do we have for value?
How is value measured? Price-to-book.
Don’t look at it in price-to-earnings. It’s a lot of times all they look at.
Or they use the term “It’s undervalued.” It’s looking for undervalued stocks.
This is why—younger investors, I look at it and go, “Well, yeah, they don’t typically hire financial advisors. Why?”
“Because their lives aren’t as complicated.”
I’m going, “No, they’re fairly complicated, but the complications are just different than older investors.”
They should be using financial advisors for different reasons, but only if the financial advisor has a degree—that’s step one—but also has a really good understanding of academic theory when it comes to investing.
I mean, that’s really where the rubber meets the road when it comes down to what they’re dealing with when they’re choosing investments in their 401(k)s at work, or their 403(b)s, or whatever they have access to.
Yeah. Not a “one size fits all.”
Typically, just like anything else, when you have “one size fits all,” one size fits nobody. We want to avoid that as investors.
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