After the market crash of 2000, many investors moved from pure equity to balanced funds. One of the benefits of holding balanced funds is that you can fall asleep at the switch for a few years and portfolios will not get hurt beyond the normal fluctuations.
The financial industry moved a step beyond the balanced funds. Target date funds were invented. These funds are designed to start with an aggressive asset mix and become more conservative over time. For example, if you are 35 years away from your retirement, they would typically start with 85% in equities and that would come down to 25% by age 65. Different fund companies follow different levels of asset mix, so you need to read the prospectus very carefully. The idea is, if I buy these funds, I can then fall asleep at the switch not only for a few years, but a few decades. Is this a good strategy?
In this chapter, we look at that.
There are three stages during accumulation: seed money formation stage, mid–life growth stage and pre–retirement consolidation stage.
Figure 19.1: Life stages during accumulation:
Seed Money Formation:
At this stage, the objective is to accumulate sufficient seed money to create a base for future growth. Some people start saving for retirement in their 20’s, some start later.
Generally, the range is between the ages of 20 and 40. I don’t want to be the bearer of bad news, but if you do not accumulate the seed money by age 40, then it will likely be too late to grow sufficient assets by age 65. Of course, you may get lucky and receive an inheritance, marry a rich spouse or write a book on retirement that sells a million copies.
But these are exceptions.
This stage should be considered complete when you have saved twice your estimated post–retirement withdrawals. For example, you might estimate that you need $60,000 per year at retirement in current dollars. If the projected government benefits provide $15,000 annually, then you need $45,000 from your portfolio upon retirement. Since the target at the seed money formation stage is to save twice as much as the post–retirement withdrawals, then this stage is completed once your savings exceed $90,000.
In theory, income earners with a pension plan need a smaller amount of savings to finance their retirement. However, companies and pension plans are not infallible; many are already in trouble. So, having a pension plan should not stop you from setting a larger target, if you can. If it turns out that you don’t need these savings in the future, you can use them to finance other dreams.
The seed formation stage is your most important and most vulnerable stage. Because there is little money in the account, you may easily be swayed from your long–term objectives. You may think that you’ll never be able to save enough money at this rate. Or, you may be discouraged by the market’s ups and downs. Family expenses and unfavorable career changes can make this process even more difficult.
Many researchers and academics consider the time horizon as the most important asset allocation factor. Conventional asset allocation guidelines point to an aggressive portfolio consisting of 70% to 90% equities for younger investors, just because this group has a longer time horizon. Ignore any such counsel.
While the time horizon is an important factor, in real life, behavioral risk is probably a more important factor at this stage. An investor with little investment experience is more likely to make wrong decisions based on emotions. The largest risk here is short–term losses that might scare the inexperienced investor out of the market. Once out, it may take years to gather enough confidence to return to investing, perhaps not until the late stages of the next bull market. After some experience with investing, about two market cycles later (about eight to ten years), this behavioral risk might decrease to a more manageable level.
Your investments might be a small amount at this point; this is all the money that you have saved all your life. You would perceive any loss to your seed money as a big loss. It does not matter how diligently you might have educated yourself about the benefits of long–term investing, when your dream is bruised, it is hard to recover.
Figure 19.2: Typical risk levels:
Picture this: you just have your first baby boy. His average life expectancy is 84 years.
Being overjoyed, you grab the baby and start tossing him up towards the ceiling, over and over again. Everyone witnessing this dangerous spectacle in the delivery room is screaming at you, in shock. Finally, you stop and explain: “Why should I worry? His life expectancy is 84 years. He has a long time horizon!” Well, not so, if you put the poor baby at undue risk.
As absurd as this scenario may appear to you, this is exactly what the financial industry counsels you to do when your portfolio is only a “baby”, i.e. during the seed money formation years. Remember, when you don’t have much money, an advisor might not be able to spend much time with you; it just does not pay. Your entire education process might consist of one single sentence: “You have a long time horizon young man, be aggressive!” Not knowing any better, you sign all the papers that he pushes in front of you on his way out to the next meeting.
I suggest that you do the opposite of the conventional wisdom; be conservative with your seed money. Do not waste it. Do not take big chances. You may have a long time horizon, but you can take advantage of it only if you have the staying power. Using the rule of 72, if your portfolio grows annually at 8%, then that means it doubles every 9 years. If you lose half of your seed money, you need an additional 9 years to catch up with that loss at the other end, at least in theory. The financial establishment will love you more if you have to linger in the accumulation stage, even for a few additional years.
Assume you have a balanced portfolio growing at 6% annually. If you start with nothing in your account and save 15% of your income regularly, it takes five years and ten months until the account value exceeds your annual earnings. On the other hand, a more aggressive portfolio that grows at 10% per year will reach the same dollar amount in five years and four months.
The difference between the two portfolios is six months. In other words, 91% of the portfolio growth can be attributed to your discipline of investing and only 9% is attributable to the difference in the growth rate (the difference of six months divided by 5 years and 10 months). Skipping a few months of deposits at this seed formation stage will hurt the portfolio ten times more than the modesty of its growth rate. During this stage it almost does not matter how much your portfolio grows, so stay conservative.
According to the US–based TIAA–CREF Institute44
Let’s look at market history to compare two different asset allocation strategies at the seed formation stage: Target Date Asset Allocation and Graduated Asset Allocation.
, a surprisingly high number of young people invest in low–interest bearing fixed accounts. They are instinctively doing the wise thing, which is preserving their seed money as best as they can. Unfortunately, the wise men of the financial establishment find this “inefficient”.
Target Date Asset Allocation (TDAA): In this portfolio, the asset mix is 85/15 (85% of the portfolio is invested in equities and 15% in fixed income) during the first eight years.
After that, it is 70/30.
Figure 19.3 Target date asset allocation
44 Jacob S. Rugh, “Premium and Asset Allocations of Premium–Paying TIAA–CREF Participants as of March 31, 2004” TIAA–CREF Institute, www.tiaa–crefinstitute.org
Graduated Asset Allocation (GAA): Here is my suggestion for the seed formation stage.
It reduces the behavioral risk during the early years and enables the investor to stick to his plan. This is how it works:
• Figure out your long–term asset allocation. Say, it is 70/30 equity/fixed income.
This will be your asset mix in 8 years, but not yet, not now.
• Start with a 30/70–asset mix. Keep this conservative asset mix for four years.
• After 4 years, increase the equity allocation to halfway between the current (30%) and the long term (70%). In this case, the half way of the 30% and 70% is 50%.
Keep this 50/50 mix for the following 4 years.
• After 8 years, set the asset allocation to 70/30, your long–term mix.
Figure 19.4 Graduated asset allocation
The most important element during the seed money formation years is to invest with discipline, month after month, year after year. The reduced volatility of a conservative portfolio will give you much–needed staying power. Once this critical survival period is over, then you have more experience to handle volatility with a larger portfolio and you will be more understanding of how markets work.
Yes, you might give up some potential for higher growth. By the same token, you will also avoid higher potential losses, which might tempt you to abandon your long–term plans. Abandoning the long term plan is much more damaging than the small benefit derived from a potentially higher growth rate at this stage. Wall Street would not care less about your losses. Ignore their drummers.
Let’s look at an example using historical market data.