Experts differ on which is the best approach to investing throughout your life. Some say to maintain a fixed percentage allocation in stocks, bonds, and cash regardless of your age. Others advise a lifecycle approach where you invest heavily in stocks while you’re young and shift to bonds and cash as you get older.
Larry MacDonald reported on a recent study by researchers Basu, Byrne, and Drew titled Dynamic Lifecycle Strategies for Target Date Retirement Funds (full text of the study is available free). The title hints at a market-timing strategy which piqued my interest.
The study compares fixed allocation strategies, lifecycle approaches, and a dynamic strategy the researchers devised. It turns out that the dynamic strategy doesn’t really involve market timing in the sense of trying to anticipate bull and bear markets. The dynamic strategy begins with a target yearly compound return expectation of 10% and makes the following choice each year:
- If your compound average lifetime return so far is less than 10%, then invest 100% in stocks.
- If your lifetime return exceeds 10% per year, then use the allocation dictated by a lifecycle strategy (more stocks if young and less if old).
So, this dynamic strategy has a built-in sense of how much the investor needs at retirement. The strategy gets conservative when returns are on track, and goes for broke with all money in stocks when lifetime returns are under par.
One finding from the study is that this dynamic strategy tends to beat the lifecycle strategy. This is hardly surprising because, on average, the dynamic strategy will have more money invested in stocks over the years, and we know that stocks tend to beat bonds and cash over the long run.
One aspect of the dynamic strategy that concerns me is that if the portfolio gets behind on its target return, it stays 100% in stocks right into retirement. This tendency to go for broke assumes that if you miss your target retirement dollar figure, it doesn’t matter how much you miss it by. However, if you were hoping for $2 million, you’re still better off with $1.5 million than just $1 million.
Apart from this problem with the dynamic strategy, there is a lot to like here. For investors who are behind in the amount they have saved, it makes sense to invest more in stocks to catch up. For those whose savings are well on track to give them as much as they need, it makes sense to get more conservative, sacrificing excess returns for greater safety.
In the never-ending search for the best investment approach, I suspect that including some amount of this dynamic strategy is better than just sticking with a pure fixed allocation or a pure lifecycle strategy.
Another problem is calibration - if you expected 10% per year from the peak of the market last year, you might never catch up to that.
ReplyDeleteIf you can get the right numbers it should work similar to rebalancing, buying more stocks when they're cheap to increase your returns.
Richard: A more sensible way to use this dynamic approach is to look at whether you are on track to get to some final level of savings. If you need future returns of more than 10% per year to save enough money, it makes sense to bump up your allocation to stocks. However, your comment still applies to this way of thinking about dynamic allocation. Recent equity price drops have put many people off track for the final level of savings they want. So, most investors using a dynamic approach would be piling into stocks right now.
ReplyDeleteOf course, few people actually stick to a fixed plan of investing. They make decisions for largely emotional reasons and justify them by calling it "rebalancing", "dynamic allocation", "market timing", or whatever other strategy justifies their actions and sounds smart.
There is a lot to like about this strategy if someone invests using either mutual funds or ETFs.
ReplyDeleteIt will tend to keep money in the market during bear markets and take profits during out-performance.
If someone truly is a superior stock picker though, there's no need to scale down his stock allocation, especially when there's little relation between the market's performance and his portfolio.
A better strategy might just look at the P/E of the market and allocate more to stocks when P/Es are low?
I hope to have so much invested that a 40% drop has no effect on my quality of life. If I were to have a $10M portfolio, and it shrank to $6M, it would irk me, but it wouldn't send me into menial labour.
Good post.
ReplyDelete"For those whose savings are well on track to give them as much as they need, it makes sense to get more conservative, sacrificing excess returns for greater safety"
I agree with this quote 100%. What bothers me is that so few people know how to achieve that goal using conservative hedging strategies. There is more to investing than asset allocation.
Market timing is alluring. You just have to look at the historical record and see there are times when stocks are above or below some plausible average for P/E, P/E10, P/B, P/S, or any number of other metrics. It's just hard to profit with this information in the long run beyond what you would get if you are just 100% in stocks. If you want higher returns you need to take on more risk (i.e. more exposure to the market).
ReplyDeleteThe paper by Basu, Byrne and Drew "Dynamic Lifecycle Strategies for Target Date Retirement Funds" is available fee of charge at SSRN:
ReplyDeletehttp://papers.ssrn.com/sol3/papers.cfm?abstract_id=1302586