Leave 60/40 behind. Say goodbye to target-date funds. Goodbye, ties.
A portfolio made up of only stocks is the best way to save the most money for retirement, make more money in retirement, make sure you don’t run out of money in retirement, and leave your loved ones the most money possible.
Put all of your retirement savings into stocks: one-third in U.S. stocks and two-thirds in stocks from other countries.
Right? No, says Aizhan Anarkulova, who is an assistant professor of finance at the Goizueta Business School at Emory University and co-author of Beyond the Status Quo: A Critical Assessment of Lifecycle Investment Advice.
Anarkulova and her co-authors question two main ideas of life cycle investing in their study. The first is the idea that investors should diversify mostly by holding a mix of stocks and bonds. The second is the idea that as investors get older, their asset allocations should go down.
In a recent interview, she said, “They don’t work for us, and I’ll tell you why.”
Anarkulova says that neither of these main ways of investing makes what she calls the “most optimal portfolio.” This is a portfolio that will maximize “retirement consumption,” which means that it will give you the most stable income in retirement when you take into account both Social Security and bequests.
Save money
Anarkulova and her co-authors studied a made-up couple from age 25 until death. They saved and invested using three different strategies: the optimal portfolio, a 60/40 portfolio, and a target-date fund (TDF). Their paper will be presented at an American Finance Association conference in January. According to what they found, investors who follow the best one-third/two-thirds investment strategy and save 10% of their income each year can have the same financial benefits in retirement as a couple who uses a balanced strategy and saves 19.3% of their income, which is almost twice as much.
Even though TDFs might seem better than a fixed-weight plan since they change investments based on age, they are not as good as people think. For a couple using a TDF to get the same financial benefits as the best equity-focused plan, they would have to save 61% more money, or 16.1% of their income.
Build up more
The study by Anarkulova and her co-authors looked at what makes people financially successful in retirement. They focused on four main outcomes: how much money people have when they retire, how much income they can make while retired, how well they keep their savings, and how much they can leave as an inheritance.
In terms of building wealth over time, they found that an all-stock investment plan does better than common default investment choices like balanced 60/40 funds and TDFs.
The best strategy, which is rebalanced once a month, usually gives you 50% more money in retirement than a balanced fund and 39% more than a TDF. Anarkulova says that this extra wealth means that people who follow the all-stock plan will have more money in retirement.
Don’t run out of money.
A surprising fact is that an all-stock strategy also does a better job of keeping savings than most default choices. Couples who put 33% of their money into stocks in the United States and 67% into stocks in other countries are much less likely to run out of money. If you use the standard 4% rule for retirement spending, a balanced fund has a 16.9% chance of running out of money, and a TDF has a 19.7% chance of running out of money.
The all-stock plan, on the other hand, is only 7.0% likely to run out of money.
“It’s not a surprise that the all-equity strategy does well in long-term appreciation, since stocks tend to have higher average returns than bonds and bills,” the authors of the study said. “What might come as a surprise is that the all-equity strategy, which is used for life, easily beats the QDIA strategies when it comes to keeping capital safe in retirement.”
A qualified default investment alternative, or QDIA, is a choice for an investment in a 401(k) plan that meets certain requirements, according to the Labor Department. There are four types of investments that the DOL says can be QDIAs: TDFs (also called “life-cycle funds”); properly managed accounts; balanced funds; and capital preservation products.
Anarkulova said that the best plan leaves much bigger bequests than a balanced 60/40 fund and a TDF.
Bonds aren’t as good at spreading risk as international stocks.
The changes in correlation between international stocks and domestic stocks are another reason why Anarkulova said international stocks are better for long-term portfolios than bonds.
Anarkulova says that monthly data alone shouldn’t be used to judge the relationship between bonds and domestic stocks because it doesn’t show the long-term investment plan. When a 30-year holding time is taken into account, things look very different.
The correlation between bonds and domestic stocks is low every month, at 0.2. This means that bonds are a good addition to a mean-variance portfolio, even though they have lower yields and standard deviation. But after 30 years, the correlation goes up to 0.5, which makes them less useful for diversity.
Anarkulova also said that bonds are not safe in real life, even though they are usually thought of as a “safe asset” in theory. Over the course of 30 years, their relationship with inflation is highly negative (-0.7), which means that inflation consistently lowers their value. Bonds also don’t have the high profits that stocks do, which could make up for these losses.
If you want to really diversify, then foreign stocks are a better choice. Their monthly association with U.S. stocks is 0.3, and it has been pretty stable over the past 30 years. On top of that, they naturally protect against long-term inflation in the United States.
Investors usually want their assets to have little to no correlation with each other, or even a negative correlation. This is because it lowers risk while keeping possible returns the same.
Getting less
The road ahead for investors who choose the best plan is not smooth, though.
During the working years of the made-up people who were studied, each approach leads to big real losses on average. The worst possible loss an investor could have during a certain time period was 42% for U.S. Treasury bills, 67% for domestic stocks, 54% for the balanced strategy, 52% for the TDF, and 55% for the optimum strategy.
The writers wrote that the optimal strategy has a 55% average drawdown that would make even the most steadfast investors uncomfortable. However, every strategy that tries to provide long-term appreciation has similar large average losses.
But it’s likely that investors, advisors, and officials are most worried about the worst-case scenarios, which are the biggest losses that could happen. According to her, their research showed that the “optimal strategy” limits losses better than these other options in the worst-case scenarios. This makes it a better choice for people who want to lessen the effects of huge losses.
She said, “What you want to focus on is up to you.” “The middle, the mean, or the right tail.”
We’re not going to go into too much detail about how the study was done. Anarkulova talked about a lot of different topics in our more than 40-minute interview. She talked about age-based probabilities, simulated earnings, periods of unemployment, the different ways that earnings can change over time, survivorship bias, stationary block bootstrap (a complex way to resample time series data), price-dividend ratios, conditional analysis, the long-term relationship between bonds and stocks, purchasing power parity, and more.
The study seems solid, and those who want to learn more about the methods can read the first draft of the study in this 70-page report. It’s worth noting that this paper has been downloaded nearly 26,000 times from SSRN.com, making it the 212th most downloaded paper on that site even though it was only posted there a little more than a year ago.
The experts’ review
What do other people think about this method?
Wade Pfau, author of “Retirement Planning Guidebook,” agrees with the writers of Beyond the Status Quo that investing all of your money in stocks over the course of your life is usually the best way to make money.
“But this gets into the whole issue of why stocks and annuities, not stocks and bonds, make the most sense as a way to earn money in retirement,” Pfau said. “Bonds aren’t really useful.” But people can use annuities instead of bonds to take advantage of risk sharing in a way that lets them spend more, just like the risk premium from stocks can let people spend more when they realize it.
In the end, Pfau believes that people who can’t handle the risk of investing all of their money in stocks will have a hard time following the advice in the paper, Beyond the Status Quo. “But if you have stable sources of income, like an annuity, to cover your basic costs, it might be easier to use an aggressive stock allocation with the rest of your investments,” he said.
David Blanchett, who is in charge of retirement research for PGIM DC Solutions, said that he has written about some of the same ideas that are in the Beyond the Status Quo study. Learn about investment horizon, serial correlation, and better portfolios for retirement.
“Over time, returns aren’t random, and historically, stocks have been safer over longer time periods and start to crowd out cash and fixed income,” he said. “So, if you could have kept your money in stocks for a very long time, you would have been richer in the past, but we all know that today… this wasn’t so clear it would have happened 100 generations ago.”
“The Beyond the Status Quo paper has a lot of hindsight bias,” Blanchett said. “The potential benefits of investing in international stocks today are a lot lower than they have been over the last 150 years.” He said that over the course of history, correlations have grown a lot.
In the end, what does he think about this study or idea? He said, “There is evidence that investors with longer-term views can and should take on more risk, but I wouldn’t go nearly as far as this study suggests—all stocks dominate a more traditional life cycle approach.” Can or will the person stay engaged for the long term? That’s the important question.
It’s hard to tell if things that happened in the past will happen again in the future, and Anarkulova agrees. “This is a study of statistics,” she said. “We are not fortune-tellers or people who make predictions.” We are telling you what is true based on where we are and what we see. It’s now your turn.
“Real people” should still invest in the best portfolio, but she warned, as Pfau and Blanchett did, “they have to be able to do it and hold it.”
It is still true that more money is better than less money, Anarkulova said.
