Paul Winkler: And welcome to “The Investor Coaching Show.” I’m Paul Winkler, talking about the world of money and investing.
Educating investors one at a time because the educated investor—harder to take advantage of you. And that’s the idea here.
So one of the topics that was very popular last year was just retirement plans in general, 401(k)s. And of course, this time of year it’s what people are thinking about.
New Year’s resolution, maybe get the finances in order. So let’s talk a little bit about just that.
Choosing Investments for Retirement
Now you may have a 401(k), 403(b), 457 plan. It might be an IRA, but in general there are concepts that are the same across them.
So I’m going to talk in general about when you’re going to a 401(k) meeting, and they’re saying, “Hey, we need to choose investments for your 401(k). What do you want to put your money in?”
Now, a lot of people are going to go, “I don’t know. I don’t do this for a living. What should I put my money in?”
And typically what happens, the salesperson just says—401(k), whoever’s handling it says—”If you don’t know what to do, just put your money in a target-date fund.”
They’re not going to choose the funds for you. They don’t want that responsibility.
“Just put your money in a target-date fund.”
You go, “Okay, great. What’s that?”
“That’s the one that has the numbers after it. So it’s Target Retirement 2040, 2035, or if you’re going to retire in the year 2050, just put your money in the Target 2050 fund.
And you go, “Okay, great. You just stick it all in there.”
Now, some people make the mistake and they choose eight different funds. “I’ll put a little in the 2025 fund; I’ll put a little money in the 2050 fund.”
And that’s not what they’re meant to be. It’s meant to be a one-stop shop: you just put your money in there.
Or you go and say, “I’ll put a little bit in this one, I’ll put a little in the international fund, I’ll put the target-date fund in 2040 fund, I’ll put a little bit in the small-cap fund, and blah.”
And that’s not what it’s designed for either, but people will do that.
The Drawbacks of Target-Date Funds
Now, target funds are something I’ve talked about many times on this show and said I’m not a big fan. And there’s a lot of reasons.
If you look at the way they’re actually mixed, typically very, very heavy in certain areas of the market. Very heavy in the areas of the market that most Americans are enamored with, which are large companies, U.S. companies in particular.
Some fund companies do an indexing approach, and they write, “Hey, we’re really, really cheap, and we use an indexing approach, and it’s really super inexpensive.”
Vanguard does this, and they’ll have—the Target 2040 fund will be in the total U.S. index fund, and the total international market index fund, and a total bond fund, and so on and so forth.
And what’s the problem with that?
Well, if you look at the academic research, where do we expect more returns, large or small companies? Well, of course it would be small companies: 83% of 20-year periods, small companies do better than large companies. 83%.
That’s a pretty high number. And what are they doing?
They’re focusing more on big companies because they weight based on the size of the companies in an index fund. Like a total market index fund, they weight based on the size of the company.
So they’re going to overweight the big companies.
Well, I expect more return of the small; that doesn’t help. Well, sheep!
So you go broke, and it doesn’t cost much. You just don’t want to do that, but that’s what they do.
And then you’ve got, for example, value companies: 96% of 20-year periods, value companies do better than growth companies. And 96%, that’s a pretty high number.
And what are they overweighting? Growth companies, in these funds. Good grief, is it a popularity contest?
Is this better for the investor? No, it’s not better for the investor, but that doesn’t cross their minds.
Active Management vs. Indexing
But it’s not just Vanguard. It’s Fidelity, they do … Fidelity, they play both sides.
They have active management, which is stock picking and market timing.
When you hear me say “active management,” I’m talking about a fund manager goes in and tries to pick which growth companies are going to do better than others, which small companies are going to do better than others, which market segments are going to do better than others.
And active management, you’ll hear that active management doesn’t do as well as indexing. And it can be really confusing because you hear that and you go, “Well, then just indexing. Why did Paul say that indexing was a problem?”
Because when they do the research, they do it right regarding that. Actively managed, small-cap fund where you’re picking stocks out of a universe of small companies does tend to underperform a passively managed fund.
Now the problem is, there’s a whole new level with small caps because you could have a fund that’s passively managed that isn’t overweighting the bigger small companies. You see how confusing this gets?
And then now you’ve misled people by saying indexing is better. If you’re looking at active, large-company growth, like a fund that’s investing in large-growth companies versus the S&P 500, yeah, it’s typically the active management doesn’t do as well.
But people don’t hear the nuances, and it just gets confusing. So anyway, back to the issue at hand here.
Remember, small companies: higher expected return than large. Value: higher expected return than growth.
And they’re overweighting with target-date funds.
Why Target-Date Funds Are Inappropriate for Many Investors
And it doesn’t matter what fund company.
If you look at American Funds, same thing: they’re overweighting big companies.
As a matter of fact, they’ve got a fund that’s called a small-cap fund, but it’s actually investing in mid-cap stocks. So they don’t even have one that invests in that area of the market.
And then you got T. Rowe Price, and you got all these different fund companies out there. Name it: John Hancock, whatever.
They have these target-date funds, and they overweight the big companies, and they overweight the growth companies. Well, this is something I’ve talked about for a long time.
Well, finally there is an article in The Wall Street Journal that has come out that says “Why Target-Date Funds Might Be Inappropriate for Most Investors.” Thank you, Wall Street Journal.
Target-date funds are inappropriate for investors.
It says if you’re a typical investor, it might be okay. And I would disagree with that because of the reasons I just said.
You might be okay if you’re a typical investor. Well, what’s a typical investor, A?
And is a typical investor somebody that likes overweighting big companies and overweighting growth companies and likes getting lower returns? I don’t know.
That’s the only part of the article that I really disagree with, but I digress. I had to read it.
There’s a finding of new research in the National Bureau of Economic Research circulating in December. Jonathan Parker, a professor of Massachusetts Institute of Technology, candidate for MIT—blah, blah, blah, and so on and so forth—did this research.
It says, “For investors 40 or so years from retirement, for example, typically around 90% of portfolio investments are allocated to equities.” In these target-date funds.
They have these glide paths. They’re going to start off with so much in stocks and then reduce the amount of stocks until you get to retirement.
The equity allocation declines gradually, and 90% is okay. If you’re young, 90% is typically fine for most people because you got a long time, not worried about market fluctuation.
And that’s where I’m in agreement with this, and that’s maybe what they meant by it’s appropriate for some people because they do tend to start with … well, no, I’m not in agreement because still you have the problem of overweighting large companies and growth companies.
Anyway.
Asset Allocation Gets Complicated
“Equities allocation declines gradually to around 50% for investors at retirement age, and to as low as 30% for those well into their retirement years.”
And they say, well, there’s a problem there. That’s too little in stocks, and I would agree.
As a matter of fact, there was another article, totally unrelated, and it was—DALBAR had done some research. Standard asset allocation models are wrong according to DALBAR.
That was in Think Advisor that they had done this article. And they say here’s the problem, is that if you look at market downturns, having that much in fixed income is way too much inflation risk.
That’s the short version of the article, but that’s the issue. When I have fixed-income investments and you have inflation, you’re losing money.
It’s not acceptable to have 50% or 70% of your money losing money after inflation. It just doesn’t make a lot of sense for most investors.
I guess I’ll say there may be some exceptions, but I can’t think of any off the top of my head. “It’s great that 70% of my money’s losing money after inflation!”
But anyway. So it says, “‘In fact, however, dozens of additional factors are relevant when determining whether a given glide path is optimal for a particular investor. Analyzing the interactions between those factors turns out to be ‘very, very complicated,’ Prof. Duarte says.”
“To illustrate, say you lose a job during an economic recession and stocks plunge. Depending on how many years you have until retirement, the losses to your portfolio might matter less than your loss of income.
“Determining proper investment allocations needs to take into account not just the stock market’s historical return profile but also your age and vulnerability of your job to the business cycle. That is difficult enough with just a few variables, but becomes almost impossibly complex when incorporating many additional factors.”
Many Factors Should Drive Asset Mix
So in essence, what this is … this is something I’ve talked about before, is your asset mix—how much I have in stocks and bonds—can be driven by a lot of factors.
How many years before I’m going to retire? How solid, how stable is your job?
If you’re in kind of a risky job, you might not want to have all your eggs in the stock market basket because the stock market can move with the economic cycles.
And just when you’re more likely to end up losing your job or getting laid off or something bad’s going to happen at your company, all of a sudden now your stock portfolio is down and you’re laid off and you need money and you have no money in fixed-income investments because you didn’t have a big enough emergency fund or whatever.
And that can play into it too: How big is your emergency fund? So that’s another issue that you think about.
Now another thing is you might have a job that is very, very much in economic cycles, are actually part of your work. And the reality of it is you may end up having to retire sooner than you thought you were going to have to retire, and you don’t want to have your job and your stock market portfolio all together.
Now, a perfect example with that would be, let’s say, a financial advisor. A financial advisor who is paid based on the assets being managed or a mutual fund manager who is being paid based on the assets they manage, all of a sudden their portfolios go down that they manage just because markets fluctuate, and their income goes down, and their income goes out and they have nothing.
No fixed income to actually pad themselves. So that would be one very obvious example of that.
So looking at how you allocate, that could be a factor in that as well is, how much at risk are you in your work? How much risk of what if you can’t work, and what if you do need some of this money a little bit sooner?
Researchers Used AI to Develop Investment Analysis
“As Prof. Parker”—and there’s another area that goes to this—“To overcome this complexity, researchers turned to a type of artificial intelligence known as deep learning. As Prof. Parker describes it, they used historical data to set up a model of the ‘game of life’—or, in other words, the ‘risky economic environment in which people earn, save and invest over their lives.’”
They’re basically kind of running this program as things that might happen. Now, we’ve used probability analysis for years in the financial planning process, and that’s just going and taking and randomizing different things that might happen.
And this is something that we’re seeing more in financial planning programs.
What if they change the tax laws? What if in 2025 they go back to the old tax laws?
What if taxes increased in the future? What if you end up going into a nursing home at a certain point in time?
And it is very much like this. So this is kind of the direction that the industry’s going, and it’s going to get really interesting.
But it says, “Each successive round, it ‘learned’” what might be different variables, which were “better or worse ways to invest a retirement portfolio.”
“The computer eventually gained insights that were beyond our reach before that,” they said. “‘No other modeling equity allocation up to this point has taken into account as many different variables.’”
And that’s the beauty of computers. When it comes to, for example, Social Security, and we think about that. And modeling that:
And what if this person dies at this age? What if this person lives to this age?
What’s the life expectancy, joint life expectancy? What are the tax changes that could actually affect Social Security taxation when you’re drawing money from a portfolio?
There are a lot of different things, so you come up with an asset allocation based on a lot of this stuff. And this is really where the industry’s been going.
Models Show Target-Date Funds Are Too Conservative
Now, it says that a “typical glide path”—a problem that they had with it—”used by target-date funds is too conservative starting at the age of 50” because you’re literally looking at what mix of stocks to bonds, and it’s just wrong. It just doesn’t work very well.
And it didn’t work in their game of life. Well, that is the problem that I’ve had for a long, long time.
And if you look at fund companies, they all do it. And you go, “Well, why do they all do it if it’s not that great?”
Well, there’s safety in numbers. If every fund company is making the same basic mistake, how do you hold any of them accountable?
You don’t. That’s the answer.
Now, this says, “Wealth. An investor with greater net worth is able to take more equity risk.”
There’s another variable right there. If you’ve got a lot of money, you got a lot of wealth, you got a lot of assets, just naturally you can take more risk with your stock portfolio.
Well, target-date funds don’t take that into account.
This reminds me of—I had done this thing a while back where I actually had these two lines. It was in a really interesting course that I had taken.
And I had one line that started off high, and it went down, down, down, and down. And then the other line started way down, and it went up.
And what it was looking at is the need for diversification.
The bottom line—the horizontal line, the X-axis—was your age.
And what the second line, the one that started low and then went up high, was showing was the importance of diversification.
And it was basically saying when you’re young, diversification really isn’t that important typically, simply because of the fact that you got so much time before you’re actually going to be living off of your money.
Now the other line, the one that started high and then went down, down, down, and then dropped off, it was basically saying diversify like crazy when you’re young because when you’re young you need to have lots of skills, lots of knowledge.
You have to have educational diversification. You have to have diversification in terms of how you earn an income.
So diversification is really, really important there, but as you get older it’s not that important because your number of years before you’re going to retire is going to be shorter. And that would be something you would play into in how to mix a portfolio.
And your level of diversification might make it so that you might be that person that, “Hey, you know what? If I feel like working another five years when I retire, I’ll work another five years when I retire, no big deal.”
The Roles of the Business Cycle and Market Valuation
Now, a couple things they had in here I wasn’t so crazy about—and it was funny because they talked out both sides of their mouth on these—but it was state of the business cycle and market valuation.
There’s where you run into the problem where they’re talking about these target date funds.
Well, they’re mainly investing in big growth companies, and historically, right now the prices on those companies is pretty doggone high compared to historic norms.
So, of course, since most target-date funds do that, they of course would have to address that in this article.
I would say the better way to address that is make sure you’re holding value stocks, make sure you’re holding international, better allocations to that, better allocations to small companies because small companies—right now the prices are not high at all compared to earnings or book values.
And value companies—much, much lower. But I could see where that would definitely be the case.
But then to their credit, they basically took that back. And they said “Researchers acknowledge that the dividend-price ratio”—which is how they measured market pricing, dividend-to-price ratio.
So what are the dividends being paid out compared to the price of the stock? If they have really high dividends compared to the price, that is a more value orientation is what they’re saying right there.
They’ve got a lot of profits for what somebody’s paying, a low price, the denominator. If you have a really, really low dividend paying out compared to price, in other words, you got further to fall is what they’re saying right there.
But it’s turned out to be a “far too pessimistic picture for equities” in recent years.
In other words, what they just said with that line is it doesn’t work. Maybe we thought it did, but it doesn’t, so maybe you can ignore that.
But I think the general gist of this that I want you to get is target-date funds, one size fits all, tends to fit nobody. And that’s the problem that you run into with these programs is they just don’t fit people’s real situations for all of the reasons that I gave.
And you might want to just, when you’re going through your 401(k), choose your own investment. Or better yet, have somebody that knows what they’re doing choose the asset mix based on your particular circumstances.
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