Seeking Alpha

Portfolioist's  Instablog

Send Message
The clatter of 24/7 investing information has made it harder and harder to focus on the core principles of smart investing. With stock tips rocketing across Twitter and the market’s every nip and pop warranting team coverage on cable TV, it’s not easy to find thoughtful information that will... More
My blog:
  • Saving And Investing For Retirement: Part Three 0 comments
    Oct 5, 2012 11:30 AM
    Realities of Investing: Part Three of Our Special Five Part Series

    In the various calculations that project retirement portfolio accumulations through time (such as the two discussed in the previous article), there are assumptions about how investors will allocate their savings and how those investments will perform. In the case of the Fidelity study, no specific asset allocation is provided that would achieve the assumed risk-free 5.5% annual return. In the Ibbotson study, the authors assume that investors hold a combination of a stock index fund and a bond index fund that progressively allocates less to stocks and more to bonds as investors get older. The Ibbotson study also assumes that the stock index (the S&P 500) will have an average annual return of 10.96% per year and that the bond index will have an average return of 4.6% per year. The Ibbotson study ignores expenses associated with investing.

    In reality, you cannot get 5.5% per year in return without taking on some risk. You also cannot invest without incurring some level of expense. In addition, making plans based on an assumption that stocks will return an average of about 11% per years is risky. I believe that the authors of both of these studies would be the first to admit that these projections for investment performance are very optimistic. If we introduce volatility to the Fidelity approach, subtract expenses from the Ibbotson results, or lower the expected returns from stocks, we can be certain that the projected savings levels necessary to fund retirement will be higher. The Fidelity and Ibbotson studies are 'best case' scenarios for investment performance.

    Beyond the performance of stocks and bonds, there is also the problem of poor investor choices and timing. A range of studies have shown, for example, that individuals tend to buy once the market has rallied and sell when the market has dropped. We get optimistic when the market is rising and fearful when the market has dropped. In addition, investors put more money into mutual funds that have recently out-performed, even though there is no evidence that past winners repeat. The funds that out-perform the benchmark in any given period are invariably actively-managed funds and tend to have considerably higher expenses than index funds. Performance chasing and market timing exact a huge cost. DALBAR, a research firm, compiles statistics on how individual investor return compares to that of the broader market. For the twenty years through 2011, the average investor in equity mutual funds achieved an average annual return of 3.49% as compared to 7.81% for the S&P 500 over this same period. In other words, even over a 20-year period when the market performed quite well, the average investor generated fairly paltry returns.

    The average investor under-performed the market by 4.3% per year due to three factors:

    1) poor performance by active fund managers

    2) mutual fund expenses

    3) bad timing decisions

    It is hard to accurately separate these factors, but the message overall is clear. Investors who try to select actively-managed mutual funds and who try to move in and out of equities through time have lost more than half of the aggregate return that would have been provided by simply buying and holding a low-cost market index fund. The same types of result are evident for bond funds. If we were to adjust the Ibbotson or Fidelity assumptions to reflect a 4% reduction in average annual return, the savings rates needed to sustain a long-term retirement would skyrocket.

    The best choice for most investors will be to maintain a sensible allocation to a series of low-cost index mutual funds or ETFs. This type of simple buy-and-hold approach would have dramatically out-performed the average investor's performance, based on DALBAR's 20-year analysis. These results are consistent with DALBAR's findings in previous studies.

    An investor's risk tolerance tends to change as she gets older, of course, so the asset allocation typically evolves over time. The purpose of target date strategies is to provide an easy way for investors to hold a diversified portfolio that becomes more conservative as investors age. The asset allocations, degree of active management, and fee levels vary substantially across the range of Target Date funds. In 2007, Folio Investing launched a suite of Target Date Folios (portfolios that investors can buy and sell in a manner similar to funds). There are differences of opinion between experts with regard to the inclusion of different types of risky asset classes over an investor's life and these differences are reflected in the range of asset allocations found in Target Date funds and Folios. Some Target Date funds include actively-managed funds (which have higher expense ratios than index funds) while others focus on providing low-cost asset allocation. The Target Date Folios keep costs low by investing in index ETFs. Target Date strategies (funds or folios) tend to reduce the worst mistakes that investors make by helping people to avoid holding portfolios with inappropriate asset allocations and by providing diversification. Even if you don't want to invest in a pre-built Target Date fund or folio, you can get ideas for your own personalized portfolio by looking at the holdings of the various Target Date funds and folios.

    Individual investors will be well-served by owning and consistently investing in a diversified portfolio of low-cost index funds. The appropriate level of risk depends on the specific needs of the investor, but the Target Date strategies provide a way to look at some of the different asset allocations designed by professional portfolio managers and analysts. For planning purposes, it is crucial to understand that the specifics of your portfolio determine the future risk and return that you can reasonably expect and these factors have a major impact on how much you need to save through time and how rapidly you can expect to accumulate wealth, as well as how much you can lose when market conditions are not favorable.

    Fund expenses, fund manager performance, asset allocation, and investor timing all have an effect on the performance of a portfolio. As we try to plan our savings rates and judge whether we will be able to meet our financial goals, all of these factors come into play. If you invest in high-cost funds and tend to jump in and out of the market, it is likely that the performance of your portfolio will be well below the market as a whole. As a result, you will probably need to save more, work longer, or both.

    In the first three parts of this article, we have focused on building wealth through time. In Part 4, we shift our attention to how investors can effectively generate long-term income from their portfolios.

    Related Links:

    Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

Back To Portfolioist's Instablog HomePage »

Instablogs are blogs which are instantly set up and networked within the Seeking Alpha community. Instablog posts are not selected, edited or screened by Seeking Alpha editors, in contrast to contributors' articles.

Comments (0)
Track new comments
Be the first to comment
Full index of posts »
Latest Followers

Latest Comments

Posts by Themes
Instablogs are Seeking Alpha's free blogging platform customized for finance, with instant set up and exposure to millions of readers interested in the financial markets. Publish your own instablog in minutes.