Posted on 04/22/2021 7:43:37 AM PDT by SeekAndFind
Would you hire a money manager that manages your wealth on false assumptions?
It seems like a bad idea, but many people unknowingly opt for such a management style in their retirement plans.
Target Maturity Funds are one of the fastest-growing mutual fund sectors of the last decade. These passive strategies are most popular in 401k and other retirement plans with limited options and long investment time horizons.
Wall Street nicknames them “set ‘em and forget ‘em” funds because their strategy purportedly adjusts risk lower as you age. At first blush, such a strategy makes sense as risk tolerance is often a function of age. However, the purveyors of these funds fail to disclose that measuring risk is a function of the prices and valuations of assets.
Changing asset allocations based solely on the calendar is playing roulette with your financial well-being.
Target Funds are passive mutual funds run by basic algorithms. The funds slowly allocate away from stocks and toward bonds based on a target future date. For example, a fund with a 2050 target date will initially invest heavily in stocks, with the remainder in fixed income assets. As the fund ages, it reduces equity exposure leaning more toward fixed income.
The table below shows how the Vanguard family of Target funds transition from 90/10 allocation of stocks to fixed income to 50/50 as they reach the target date.
Target date funds are based on one simple thesis- as we age, we should reduce financial risks.
There is sound logic to lessening financial risk as you age. First, there are fewer years of future income and investment gains to make up for potential investment losses with each passing day. Second, for those entering or already in retirement, the stability of wealth to cover current and future living expense is critical.
Target funds fail in their complete lack of consideration for measuring risk. Equities, for example, are inherently riskier when fundamental valuations are above average and recent performance has been strong. Conversely, they are less risky at low valuations with beaten-down share prices.
To better understand the problem with allocating based solely on a future date, we start with the graph below. The chart makes it appear as though the S&P 500 is a reliable growth machine. Why not have a strategy that relies on the trend continuing?
Unfortunately, for us mere mortals, with 10-30 year investing time frames, we best zoom in on the graph in shorter time horizons.
Shown below is the same graph but annotated differently. The red lines represent extended periods where the index had negative returns. The red bars quantify how long those periods lasted.
Stocks rise over very long periods, but shorter periods often see long periods of consolidation with no upward progress. If you were unfortunate to start investing in 1929, it was not until 1954 till you saw prices back at 1929s levels. But for those that started investing in 1951 or 1981, the equity market trend was primarily upward.
The start and end dates of your investment time horizon matter greatly. Blindly allocating to equities based on age and failing to account for market risks is a recipe for failure.
Quite often we hear investors state the future is unpredictable. Accordingly, they claim equities offer much better historical returns than bonds. As such, why not roll the dice on history and go all-in on equities.
No one can tell you with any certainty what stocks will do tomorrow or next month. However, looking further into the future, market returns become easier to forecast. The graph below shows stock returns become increasingly dependent on valuations as the investment horizon increases.
The next graph shows 10-year rolling returns on the S&P 500. The simple takeaway is that returns are cyclical.
Periods in which equities are overpriced with high valuations are followed by periods with lower returns. Conversely, periods when stocks are cheap, are often followed by periods of strong returns.
To better stress the point, the following graph compares ten-year forward annualized returns to 10-year prior annualized returns. Quite often, the two lines mirror each other. For example, for the ten years ending March of 2009, the market returned -6% annually. The annual return for the next ten years was over +14%.
Now we focus on fundamental valuations, or how much investors are willing to pay for future earnings.
The following graph shows when valuations are low, forward returns tend to be higher and vice versa.
To further illuminate the strong correlation between valuation and returns, we present the same graph above but with the right-hand Y-axis (returns) in inverse order. Again, the higher the valuation, the lower the returns in the following ten years.
In almost all cases, aversion to risk should increase with age. The problem is that target funds do not assess risk, just your supposed tolerance to risk. There have been multiple times in history when valuations and prior returns were well above average. At these times, a 30-year-old with a passive equity-based strategy should have reduced their equity exposure. Conversely, there are times in history when prices and valuations were so beaten down that a 70-year-old should have had high exposure to equities.
We picked on equities in this article, but the same logic applies equally to bonds and most other asset classes.
Today, valuations stand at extreme highs. We should expect annualized equity returns of zero or even below zero based on the regression of historical returns and valuations. If your wealth is actively managed, current high exposure to equities is fine. The advice assumes you or your manager is aware of the risks and ready to act if necessary.
Most 401ks offer their participants many alternatives alongside target funds. For those that elect to take passive strategies, like target funds, we strongly advise that you assess your risk profile and that of the markets and invest accordingly.
Good question.
The way our government and oligarchs are destroying the dollar the only “safe” bet is tangible items like silver, gold, ammo and land. Also, cashing out of debt as well. When the US goes “digital dollar”, watch out!
Ammo is close to worthless now against the powers that be. It’s mostly for show.
Or just keep working.
The author makes some good points. But many investment advisors hate Target Funds simply because those funds usually don’t generate large commissions.
Just sayin’.
Thanks for another thought provoking article.
Real estate might have been something that should have been mentioned in the article as well. A home is the asset that even these days most people invest more money in than “equities” and bonds. Because of low interest rates and a variety of other factors home prices are way up all over the country. It has gotten to the point where the risk of a reversal is getting much more likely. Whe real estate starts trending downward it typically casuses a lot of pain for real people.
“We picked on equities in this article, but the same logic applies equally to bonds and most other asset classes.”
No, it doesn’t.
Bonds are the most important factor in why this type of fund has risks that people don’t take into account.
Interest rate risk is real, and when interest rates are near historic lows as they are now it doesn’t take much of an increase in interest rates to pummel the value of bond holdings within the portfolio. And if you are older and find yourself with a 50-50 balance between bonds and stocks you might think you have less risk...but you don’t. You likely have more risk as a result.
The Federal Reserve wants higher interest rates. The current massive overspending by the Federal Government will surely provide it, along with the global recovery from Covid.
Once again, Interest rate risk is, IMHO, a greater risk than market risk.
If you own stocks, you own operating businesses, not dollars.
bookmark
I agree with that statement. I keep my 401(k) mostly in index funds, which the people managing the plan hate because they generate the lowest commissions. Every now and then I have an index fund get discontinued in my plan and they will "as a convenience" move me into a fund with high commissions for them. So even when you use a "set it and forget it" tool for your plan, you still have to manually make changes yourself every now and then.
These also put at least 10% in government bonds, which are tax-free investments in a tax-free account, squandering interest on corporate bonds, which are higher.
I didn’t realize this at first in my 401K and when I saw that, I changed out.
You make a good point about bonds, and interest rate risk. As you noted, many folks aren’t aware of that. I wonder if Target Funds reduce the duration of the bonds as the person gets older.
“Municipal bonds, Ted. I’m talking double-A rating. The best investment in America.”
Vanguard tell me I’m not invested enough in bonds. Why would I invest in bonds at historically low rates? That’s riskier than the stock market.
Plus, you know, when you invest in bonds, you’re getting the leftover debt that the hedge fund “masters of the universe” passed on.
And the Fed has been propping up the “safe” corporate bond market:
I’ll pass thanks.
Those are also a bad choice in an already tax-free account, and not the best choice to blindly make, but I can say my great uncle, a Republican, did very well telling his investment advisor to simply “invest in anything good that minimizes taxes.” That wound up being a large amount of muni bonds that he was shocked he had done so well with.
I miss him and my great aunt. They gifted a bit out to the largest circle of their extended family years before they died (to the gift tax limit so as to not have to report it).
Good points in the article.
The most important ingredient is putting aside money for savings in the first place. Many won’t do that.
If one saves and invests a good amount over decades they will be rewarded with a shot at a decent retirement.
No fan of target investments. Prefer indexed funds in the overall market with control over asset allocation.
Early on - all in on stocks and then starting to throttle back to more and more cash and bonds as you get 5-10 years from retirement.
Ammo is not a bad investment or hedge against inflation. I don’t even view it for its intended purpose when considering it as an investment. I am certain it will go up in value because many people will always want it.
LOL, when I ping Ferris on a post, that’s a clue.
Pew,Pew!
I agree.
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