(upbeat music) - Welcome to the "Bogleheads Chapter Series." This episode was hosted by the Metro Boston Bogleheads Chapter and recorded April 23rd, 2022. It features Chris Pedersen of the Merriman Financial Education Foundation discussing several simple and effective portfolios which offer massive diversification appropriate for both accumulation and retirement stages.

Bogleheads are investors who follow John Bogle's investing philosophy for attaining financial independence. This recording is for informational purposes only and should not be construed as personalized investment advice. - We're fortunate enough to have Chris Pedersen from the West Coast with us here today. And Chris volunteers at the Merriman Financial Education Foundation, a nonprofit run by Paul Merriman with the goal of providing financial education and tools to investors to make informed decisions.

For several years, I've been listening to the Paul Merriman's podcast and I heard about Chris's research. A few months ago, I watched a presentation Chris did in 2020 on the topic he's gonna speak about today. And I was impressed by the research that Chris and the Merriman Foundation have done and also how Chris can take complicated data analysis and explain it in a clear, concise way.

Chris, I thought I'd start by asking you a few questions so our audience can get to know more about you. - Sounds good. - Okay. You were an engineer working in Silicon Valley until you retired. How did you meet Paul Merriman and how did you get involved with the Merriman Foundation?

- Well, I was an engineer in Silicon Valley and I was, you know how you get that kind of spidey sense that maybe a change is coming and maybe retirement is coming. I kind of thought that was what was in my near future. And I knew that that meant I needed to become a better investor.

So I started listening to podcasts, reading lots of books. And I was like you, I was impressed with the work that Paul did. He just didn't have any conflict of interest. He was motivated by one thing, to help people. And so I thought, well, if I could reach out to him, maybe I could volunteer.

That was something my mom always did. She volunteered to work with all kinds of impressive people. And to my surprise, Paul said, yes. He said, I've got some cool projects, you know, would you want to work? And it was like, great. So I started working with him and that gave me access to a huge amount of data and research and perspective and more than anything, the opportunity to try to teach things I was learning because you always learn better when you try to teach.

So that was how I got started. I mean, it was really just a phone call. - Okay, great. And can you tell us a little bit more as director of research about, you know, the research and the work that you do at the Merriman Foundation? - Yeah, we, you know, we try to essentially become time travelers.

We have return sequences that go back to anything from the 1990s to about 1928. And sometimes there are gaps in those return sequences that we have to fill in. So we get, you know, we do the very best we can leveraging all the various data sources we can find to do that.

And then when we have those return sequences for different asset classes going back into the past, we think about interesting investor questions like, you know, does it make sense to rebalance more or less frequently? Does it make sense to just invest in the S&P 500 or diversify more broadly?

And we had, up until I joined the organization, all of our work was with fixed allocations, but I wanted to do some work with target date funds, which have time varying allocations. So a lot of what I do is building back testers that will take a time varying asset allocation across a lifetime and a number of assumptions about how somebody's cash flows look and figure out how it would have performed in the past.

There's no guarantee the future will be like the past, but we have no way to know what the future would be at all unless we base it on something in the past is the best predictor we've got. So it's fun. We work with a lot of really interesting questions and we get a lot of interest.

I'm hoping to get some interesting questions at the end of the presentation today. And I learn as much from those as I do from the work I do with Paul. - Okay, great. Well, now that we know a little bit about you and your background, I'm gonna turn it over to you.

So go ahead and start. - Let me see if we can get this sharing set up right. - One thing, Therese, is that the saving of the chat would be at the end of the presentation. If they save it now. - Are you seeing the presenter view or are you seeing the presentation?

- We're seeing the presentation. - Okay. - Excellent, okay. So, man, I can't believe it's been two years since I first did this presentation. And I hope that this new version can live up to the kind introduction Therese gave me. When we did this two years ago, one of the criticisms I got was that our analysis only went back to 1970.

So today I'm going to be doing some analyses that go back to 1970, but we're gonna extend where we can back to 1928. And that'll give us a scarier picture because it includes the great depression, but it'll also give us a more realistic picture because from 1970 until now was a relatively strong market for bonds.

And by going back to 1928, we'll include the good news, the bad news, and everything in between. And I think it'll give us more confidence about the conclusions. So we're gonna talk about simple and effective balanced lifetime portfolios. And before we get started, because I'm talking to bogleheads, I have to mention the three best pieces of advice that I remember hearing Jack advocate.

One was buy right. The second one was hold tight. And the third was don't peak. And I think in many respects, if you had to just give somebody six words, those were a wonderful set of six words for investing. The focus of today's presentation is mostly gonna be on buy right.

And I know that for Jack Bogle, buy right meant the S&P 500 or a total market fund. And I really don't have anything against that. I think it's fine. I think it's great advice. And I think for people who aren't willing to learn more about investing and aren't willing to study it a little bit, it's probably the right place to stop.

And that's probably why Jack stopped there. I think if you do have an appetite to learn more though, there are other opportunities for meaningful diversification that at least historically have had really significant advantages. So let's talk about what some of those are. When we talk about simple balanced portfolios, the reason I'm excited about it is that they give us an ability to control the return risk trade-off that we're gonna get.

And sometimes even improve the return per unit of risk that we're taking. They give us the ability to have higher safe withdrawal rates or higher survival rates sometimes in retirement. At least that's what the history says. And they're easier to manage than 20 stocks or 50 funds. There's a lot of complex ways to get to the same place, but why be complex if you don't need to be?

So we'll talk about the simple paths and then we'll talk about the trade-offs that we give up for that simplicity. What we'll cover today are first of all, what balanced portfolios are. Second of all, what we can do with a few funds in a fixed allocation. And then third, what we can do with a few funds in a time varying allocation, like a target date fund.

And we'll in each case, look at how they differed during accumulation and during retirement, because those are dramatically different phases of life and they have different priorities. And finally, we'll talk about what we give up by being simple and hopefully have time for question and answer. So balanced, let's just start with the word.

What does balanced mean? Most of us have ridden a bicycle, so you know about left and right and staying balanced. And so one definition is an even distribution of weight, enabling someone or something to remain upright and steady. A second definition, which starts to get closer to what we're gonna talk about today, is a condition in which different elements are equal or in the correct proportions.

And then the third and most specific to investing would be an investment strategy, which balances risk and return by combining different assets, such as stocks and bonds. And we'll look at all of those, but let's start just to kind of get our minds going. Let's start out of category.

Let's start with something I'm very passionate about, perhaps even more than investing, food. So balanced flavors. If you were to start thinking about trying to be a great chef, you'd probably have on your mind the idea that you need to balance flavors. And you would probably think of the world, at least I do, like this.

There's tens of thousands of ingredients. There's tomatoes and chickpeas and onions and steak and cereal. How do I balance them all? And the good news is that through science over the course of the last 100 years, chefs have come to realize that there are six underlying key attributes and that foods kind of cluster in these key attributes.

And those are spicy, sour, sweet, salty, umami, and bitter. And that some of these attributes balance one another and some of them compliment one another. And that you can make fantastically tasty meals by properly selecting among them and combining them. And that the best things are usually a combination, not just one note, not just salty, not just sweet.

Although many of the fast foods we eat are just that. But the best foods, the meals that we probably remember the most are usually an artful combination of all of these. Well, it turns out you can look at investing much the same way. If we look out at the kinds of stocks or companies we could invest in in the world, there are thousands, thousands and thousands of companies and trying to figure out how you would choose among them and why you would choose certain ones over other ones and which ones might compliment one another or which ones might balance one another is a very difficult task.

But fortunately for us, academics have done an exercise much like the food scientists did and have figured out that there are key attributes both in the fixed income or bond space and in the equity or stock space. So in the fixed income or bond space, there are basically two attributes that really matter.

One is the length of the bond or the term. And you can imagine if you are gonna, if you think of the bond as a loan, if somebody is gonna loan you money or you're gonna loan somebody money and buy a bond for one year, you would probably accept a smaller return or interest rate than if you loaned the money for 20 years.

'Cause who knows what's gonna happen with inflation over 20 years. So the longer the term or the longer the duration of the bond, the more you're gonna ask for in terms of a return in interest and you're likely gonna get it. Credit's a similar kind of thing. If you loan the federal government in the United States money, they can print money and give it back to you.

You're gonna get paid back. The money may not be worth quite as much, but they could do that. If you loan money to a fly-by-night business that's on the verge of bankruptcy, you're gonna ask extortionist rates and you might get it. And so in bonds, these two attributes, term and credit, pretty much define about 98 to 99% of the return experience you're gonna get in terms of the volatility and the compound annual growth rates.

In stocks or equities, there are five attributes that the academics have found and generally agree upon. The first is market risk. And that's the idea that by investing in the stock market, you're going to see the value of your money or your investment go up and down as all kinds of unknowns come to pass.

Earnings go up and down. The economy changes. There's geopolitical news. And so you're going to expect to be compensated for that. And historically, if you invested in the S&P 500 or a total market fund, you were. You were compensated for that. You got a return of between 6% real and 10% nominal.

So you get a return. The second one is size. Smaller companies tend to be more volatile. So investors tend to expect to and get a higher return out of investing in smaller companies. Not always, but they tend to, and particularly higher quality smaller companies. And we'll take a look at that in a minute.

Value is the third characteristic. And this basically says that if you buy parts of the market that are out of favor, they're not inflated in price, you're going to have a kind of a buffer, a cushion, if you will, a margin of safety that potentially will deliver you a higher return in the future.

And historically has delivered a higher return. The next two qualities are momentum and the quality attribute or factor. And momentum basically says things that have been going up continue to go up until they don't. So the trick with momentum is that, although the companies that have been going up tend to continue going up, you have to keep watching them.

And when they start to go down, if they go down for a certain amount of time, you have to trade out of them. So momentum is a more active strategy. And then quality says companies that have better financials or better moats to defend against competition do better. So this is all kind of airy-fairy and fuzzy, but the key takeaway, if you back up to the 10,000 foot view is that in the same way that there are these attributes that drive a tasty meal, there are a handful of attributes that drive a high performance portfolio.

And we're going to look at how they have actually done in the past and how they performed. But before we do that, let's look briefly at how available they are. So if we're looking for market risk, there are literally thousands of US stocks or funds that give us access to market risk.

And what I've defined as meaningful access is greater than 30% of the premium that the academics have discovered. So pretty much every stock fund you could invest in, whether it's a mutual fund or an ETF, is going to give you exposure to the market risk that we just talked about.

The size risk is available in 1,000 plus funds. The value risk is available in about 1,000 funds. You can get market size and value risk in about 500 funds in the United States. You can get market size value and quality risk in about 300 funds in the United States.

So these would be called small cap value funds, and they are the original multi-factor fund. If you go out and look for multi-factor labeled funds, you won't find that many. But if you invested in a small cap value fund that also screens on quality, you're in a multi-factor fund.

And we'll see why that's important in a little bit. If you're looking for funds that deliver meaningful exposure to momentum and quality, they are rare. They're hard to come by. And it's because momentum is a costly attribute to get in the market and involves a lot of trading. There's inefficiency associated with that.

And if you're looking for quality, too much of it's absorbed in these other funds. Everybody tries to screen on quality and the quality specific funds, there aren't that many. So if we're looking into somebody's kitchen, their 401k, they're trying to cook their portfolio. What do they have? What are their ingredients?

Well, basically they have two staple ingredients. They have stock funds and they have bond funds. And almost every 401k or IRA is gonna have access to those. And then they have spices and there's a mild spice and a strong spice. You could have a large cap value fund. Many 401ks do.

If you're lucky, you'll have a small cap value fund because that's a stronger spice. And as we'll see, working with the stronger spice is a better way to diversify because it's more different. It's more different than the fixed income. It's more different than the all stock portfolio. So if we were to look now at how they've performed in the past, do they do what I say, right?

Do they, did they really, could you really buy this? That's another way to look at it. And did it really make a difference? And you can test this at PortfolioVisualizer.com. Tuomo runs a great site there. It's free and you can go back test asset allocations into all of these assets that are on the board, the value, the blend, the growth, the large, the mid and the small.

And you can see how they've performed since 1972. And what you'll see, I got to grab a marker here, is that Large Cap Blend, let's see. Yeah, so Large Cap Blend has delivered about a 10.55% annual return. And interestingly, the total market has also delivered about a 10.55% rate of return.

And it's come at a cost, if you will, a behavioral cost of tolerating a 51% worst drawdown. So you had to be willing to lose 50% of your money on paper, but if you stuck with it and you endured and you didn't bail when the market was down, you got the return of 10.55%, which isn't too bad.

That's actually amazingly good. What's interesting is that the total market did about the same thing as Large Blend. Now, how can that be, right? How can it be that when I add in the mid caps and I add in the small caps and I add in the growth and I add in the value, I get the same return?

Well, first of all, the mids and the small don't make up a lot of the market. The bulk of the market, 80 plus percentage of the market is in these large companies. So they just don't add a lot of weight. And then the other thing that's true is when you add the value and you add the growth, they cancel each other out.

You don't have a tilt to either value or growth. You end up back at the same place you started. You end up with Blend. So this area, this Large Cap Blend that I've highlighted, that's essentially what you get with the S&P 500. It's also pretty close to what you get with the total market.

Now, I said we have two spices we can spice things up with. If you come over here to Large Cap Value, you can see you get about 6/10 of a percent higher rate of return with a little bit higher volatility, about 4% more or worse drawdown that you had to tolerate.

The drawdown is how much your balance declined from its peak or how much the account got smaller from its peak before it turned around and started coming back up. If you look down here in the bottom left, though, look at the strong spice. 13.94% was the compound rate of return.

So that's over 3 percentage points, almost 3 and 1/2 percentage points of compound annual rate of return benefit for spicing the portfolio or investing in the strong spice. And it came with a little bit more volatility. Now we're at 56% drawdown, but not much, not much. So the return per unit of risk in small cap value is actually the highest of anything on the chart.

Interestingly, the worst return per unit of risk is in this bottom right-hand corner in small cap growth. So in some respects, there are two lessons here. One is you want to spice things with value and small. But the other is you want to avoid small cap growth. You want to avoid that part of the market that's in the bottom right-hand corner.

And again, if you buy the whole market, you get them both, and they kind of cancel each other out. So let's take a look at what things look like without inflation. Let's look at real returns. And let's simplify it down to our three key ingredients. We've got bonds down here in the bottom left.

We've got stocks up here in the middle. And we've got small cap value stocks over on the bottom right. And they kind of form a triangle of returns. And now we're looking at returns that are real, which means without the effects of inflation or with inflation removed. So we can see how our buying power is increasing.

And what you see is that the compound annual growth rate for bonds-- this is intermediate term government bonds-- is very low. It's about 2%. And not surprisingly, that doesn't enable you to take much out safely in retirement. It only has a 40-year safe withdrawal rate of a little bit less than 2%.

But it's very safe, only minus 9%, worst case drawdown. If you look at stocks, now we're talking about a meaningful engine to drive good returns. You get 6.8% going back to 1928. That was the median compound annual growth rate after taking out inflation. That's really strong. But you had to tolerate a worst case drawdown of 83%.

And it generated a 3% safe withdrawal rate. It's better on safe withdrawal rate, but worse on drawdowns. And if we look at small cap value, obviously the highest compound rate of return, but also the worst drawdown. And interestingly, not the best safe withdrawal rate either. The best safe withdrawal rate on this chart is right up here.

It's for all stocks. So does that mean we should just be all stocks in retirement? Well, we haven't looked at what happens when you combine these. Let's take a look at the combinations. So if we look at the middle of each side-- so that would be a 50/50 combination of stocks and bonds, or a 50/50 combination of stocks and small cap value, or a 50/50 combination of bonds and small cap value-- the highest safe withdrawal rate is actually down here on the bottom now, which is starting to speak to this idea that depending on the meal you want to eat, the ingredients that you use may vary.

If you want the safest retirement portfolio out of these combinations, it would probably be this one at the bottom. It doesn't have the lowest drawdown. It's got a drawdown of 60% out of the ones on the sides. But it's got a really strong compound rate of return at 6.8%.

If you want the lowest drawdown out of these 50/50 combos, it's right over here. It's the combination of 50% bonds and 50% stocks. These are US stocks, by the way, going back to 1928. And if you want the highest rate of return, it's over here. It's the combination of the 50% stocks and 50% small cap value.

So we're starting to play around with mixing this up. And if you want all the gory details, if you want to see all the 10% changes, I've got it going back to 1928 and 1970. This is out of my book, Two Funds for Life. I'm not going to spend any time on those.

They're just too complex for this. But I will make the point that the highest safe withdrawal rates always come from a combination of these asset classes, not from the extremes. And I think that leads nicely into this idea of a balanced portfolio, having a little bit of a lot of different things rather than all one.

So some of you, if you're still with me, are probably thinking, but I don't want to cook, right? I don't want to be combining all these ingredients. Just give me the fast food meal or give me the microwave dinner. And we can do that. We can talk about some microwave dinners, some really easy ways to get things done.

And in fact, most of the rest of the presentation, we'll talk about that. And there are two categories that I think are really interesting. The first is a set of funds called balanced funds. You can get them from Vanguard in their life strategy funds. You can get them from a lot of other providers as well.

And the second is something called a target-based fund. And many of you are probably familiar with it. And whether you use it or not, you almost certainly know somebody who does because they're the default for a lot of new 401(k) programs for employers. Let's start by looking at these life strategy funds with fixed allocations.

And we'll start by looking at the Vanguard life strategy funds. I've pulled up four of them here. And they go from a 20% stock, 80% bond allocation to an 80% stock, 20% bond allocation. And the way Vanguard describes them is they go from low to moderate, to moderate, to moderate to high, to high risk.

That's their definitions. They're all a balance that tilts a little bit more towards the US, like 60% US, 40% international. But we can run the back tests and see how they did historically. And what we see, not surprisingly, is that as we add stock, we go from a 6.4% median compound annual rate of return to 7.6% to 8.6% to 9.3%.

It's a pretty steady 1% increase with each step up in how aggressive we're being. But look what happened to the drawdown risk. You had to take a lot more risk or tolerate a lot more volatility to get it. This 2080 fund had a 20% worst case drawdown. That's not bad.

The 4060, even though it only gives you 1% higher compound annual rate of return, had almost twice the drawdown risk. And the 6040 was 54%. And the 8020 was 66%. So these higher returns accumulate over time. But somewhere along the way, you're going to have to have conviction to tolerate a much bumpier ride to get it.

Now, these numbers go back to 1928. If I went back to 1970, they'd be maybe 2/3 the size. So your ride may not be that bad. But it's nice to know it could be, just so that you're ready and ready to stick with whatever investment it is you pick.

We can also look inside these portfolios and see which of those key attributes they're firing on. And all of these funds fire only on three. They fire on the market risk, the term risk, and the credit risk. That's it, just three. We can also look and see what their safe withdrawal rates are.

And kind of interesting, if we look at the safe withdrawal rates, they increase across the board. The highest is over here with the portfolio that has the bumpiest ride. It has the biggest drawdowns. But it also has the highest safe withdrawal rate. So I think the key takeaway here for a retiree is that it makes sense to keep your equity engine alive.

Don't get too conservative in retirement, especially if you need a higher withdrawal rate. Because having a portfolio that can't withstand whatever withdrawal rate you need increases your risk of running out of money or falling on a bad sequence of returns that basically put you out of business. So that was a set of things you can do with one fund.

All of those are just one fund. But they all fire on only three of these attributes. What would happen if we brought in some more of the attributes, if we spiced it up a little bit? Well, why would we want to spice it up? If you go and take a look at Andrew Birkin and Larry Suedro's excellent book, Your Complete Guide to Factor-Based Investing, one of the really interesting things you'll learn is that factors tend to show up at different times in the market.

So that means that when one's going up, the other one might be going down. Or when one's going up a lot, the other one might be going up a little. And we kind of knew intuitively, when you combine things that zig and zag at different times, you have the potential to smooth the ride.

And a multi-factor portfolio, or one that fires on more of these attributes, tends to disappoint less often. And you can see that over here on the right. A market-only fund, that would be like a total market or S&P 500 fund, at five years has about an 18% chance of not delivering the return that you expect.

In contrast, at five years, a fund that has exposure to market, size, value, and momentum has about a 5% chance of underperforming. So the difference there is pretty dramatic. You're talking about a factor of three increase in the likelihood that you're going to get the return that you expect.

I think most of us would like that. We'd kind of like to have more predictable performance. So let's take those two of the two funds we looked at, or the four funds we looked at earlier. Let's look at the Vanguard Life Strategy 60/40 and the Vanguard Life Strategy 80/20.

We've already analyzed those. And let's slide something in between. A 60% stock for-- Chris, you've muted yourself. How long have I been muted? You muted right about when you first started with the 60/40 Vanguard Life Strategy fund, and you added your spices. Excellent. OK. Well, thank you for telling me.

Sorry, I have no idea how that happened, but I'm glad we're back. OK, well, so what I've done here on this chart is we've brought back the same analysis we had before with the 60/40 stock bond, Vanguard Life Strategy, and the 80/20. And we've slid something in between, which is a 60/40.

So it's the same equity bond mix of the fund on the left. But we've done it with 35% US small cap value and 25% international small cap value. And the interesting thing is that we get a much higher compound annual rate of return than we do with the other 60/40.

Not surprisingly, I guess. We took more risk. We added in this volatile class, our spicy mix of small cap value. But the drawdown, the worst case drawdown, only went up by 5%. So our return per unit of risk is much higher. And interestingly, our return is also higher than the 80/20 would have been had we just gone with the Vanguard fund.

And our drawdown is better than the 80/20 would have been. And why is that? It's because of this diversification down here. We have far more working for us. We have the market exposure. We have the term and the credit exposure. But we also have value and size working for us.

So it's a multi-factor kind of approach, even though we're just doing it with small cap value and total bond funds. The safe withdrawal rates also went up. The highest safe withdrawal rates are with this-- it seems like kind of an extreme allocation because it's heavy on small cap value.

Would I recommend that a retiree invest in this portfolio? No. But as a teaching moment, I think I would point out that it might benefit them to have some in small cap value because it's going to improve their return per unit of risk, and it's going to improve their resiliency in retirement.

So with that, that's kind of our fixed allocations. Let's take a look at time-varying allocations. And to set this up, first of all, we have to think about, well, why do we change our asset allocations over time? Why would we not just have the same asset allocation our whole lifetime?

And some people do. Some people have the temperament to be stocks their entire life. And that may work fine for them, but it's not in line with what most people would describe as our risk capacity as we go through life. I think a stock allocation that's 100% through life works primarily for somebody who's an over-saver and who has incredible behavioral skills as an investor, the ability to ignore the ups and downs of the market.

But for most of us, especially those of us who are going to be just enough savers, it's really important to understand that our risk profile changes with time. When we're young, when we're over here in this early part of the chart on the left-hand side around age 25, if we lost our whole net worth, we've still got a lifetime to work to earn it back.

We have 40 years probably of career for earning and letting not just our work earn us money, but letting the market earn us money as well through compounding. Halfway through our career, we've got a lot less. And when we're nearing 65, we're nearly done. Most of us are not going to be able to work another 20 or 30 years at age 65, let alone want to.

And so our risk capacity is declining with time. And our ability to have the market work for us is declining with time. It's only natural then that our portfolio risk would also decline with time. And the industry taking this into account has invented this amazing tool called a target date fund.

You can get them from Vanguard now for 0.08%. So eight basis points gets you effectively a robo-advisor. And what it does-- we'll talk about Vanguard specifically, but what they do in general in the market is they follow a path of decreasing allocation to equities and increasing allocation to bonds.

And that's called a glide path. So this is an example of the industry average target the glide path on the right-hand side. And you can see that the equities are declining over time, and the bonds are increasing over time. And they do that not just to retirement, but through retirement.

And if we looked at the Vanguard glide path-- you can see it on the right here-- you can see that they start ramping down about 40 years before retirement, and they ramp through to about seven years after retirement. And their early allocation is about 90% equities. And the way you use these, and the way a lot of new investors are defaulted into them, in fact, is by year.

So if I was a new employee at a company, I'd probably get an email that said, we're going to invest 3% of your paycheck automatically into the-- if I'm 25 years old and I've got 40 years to work-- maybe it's the 2065 target date fund. And if I do nothing, that's what happens.

I can increase it. I can change it. But a huge amount of today's assets in 401(k)s are in target date funds. And the question is, is that good? Is it good? And I think it's not good. I think it's wonderful. And the reason I think it's wonderful is that if we were to look at a lifetime investor who, on first chance, when they are faced with this 401(k) decision, says, I'm going to put 10% of my income into the target date fund.

And they do that for 40 years of working. And then at the end of those 40 years, decide to take 4% out the first year and increase with inflation for 30 years of retirement. That 10% that they invested will turn into a pile of money that is much, much bigger than-- well, not much, much bigger, but about the same size to a little bit bigger than everything they earned in real dollars.

This is after adjusting for inflation in real dollars. And they'll have about half of it to spend in retirement and half of it as legacy. So just pause and think about that for a moment. This single investment, one tool that you can automate and put in the background for your entire lifetime can double the amount of spending power you have.

I think it's just magical. It's an incredible tool. I don't think it's perfect, but I think it's designed for the masses, and it serves them well. And I think many, many people would be as well off doing this as 90% of the other choices that they're likely to make.

So it looks like it works most of the time for most of the people. But does it do exactly what it says it does? Well, let's take a look. If you went back and looked at a lump sum investor and you analyzed all of the different months they could have started from-- I'm only going to 1970 here, but January 1970, February 1970, all these different start months when their career might have begun.

And you look at the worst case drawdown that might have been experienced across all of those lifetimes, you get this line down here at the bottom that goes across. And it shows that their worst risk exposure is in these early years from age 27, 28, something like that, through about age 40.

And then it declines all the way out to retirement. It looks like it's doing exactly what it's supposed to do, but there's a problem. And the problem is that it's based on a lump sum investment. Almost no one starts with a lump sum investment saving for retirement. We generally start with practically nothing and contribute monthly.

So what happens if we do monthly contributions? Well, now we get a totally different picture. Now we don't actually see much risk in these early years at all. In fact, we see a lot of wasted potential for taking risk. And the worst drawdown doesn't occur until age 40. It's about 42%.

And yes, it does decline towards retirement. And why is that? How could that be? What's going on here? Some of you probably know. What's going on is contributions. And by the way, I've taken these drawdown numbers just before the next contribution, so they're worst case. But if you ask a young investor when the market's down how bad their investments have done, almost none of them have run an IRR calculation and can tell you.

They just look at their balance and say, well, it's bigger than it was last year. It doesn't look too bad to me. And people who advise young investors actually see that. And if you don't believe me, we can actually look at a back test here. I chose a volatile asset class.

This is small cap value. We started in 1970. And this grayed out deep drop right here is what a lump sum investor would have experienced. And these shallow dips up here are what the dollar cost averaging or the annual contribution investor experienced, much, much shallower drawdowns. And it's because they've got these regular contributions.

So with that in mind, knowing that there's a little more room for risk, we'll analyze the target date fund. But let's also look at some simple ways we could spice it up. And these are three strategies that come out of our two funds for life book. One is easy, and this is simply a 90/10 allocation, 90% to the target date fund, 10% to small cap value.

And it's not rebalanced during the early years. And then it is nudge withdrawals in the retirement years. Now, what do I mean by nudge withdrawals? I just mean you take your whole withdrawal out of whichever fund is too big. So you've got a 90/10 allocation. If the target date fund is 11%, you take your 4% withdrawal from that.

If the target date fund is at 91%, you take the withdrawal from that. So it's simple, and in my back testing, it works pretty well. And it avoids having to make a lot of emotional decisions about rebalancing. The second strategy we'll look at is a moderate one that starts at about a 60% allocation to US small cap value and declines all the way down to the full target date fund, 100% in the target date fund in retirement.

And that's the moderate two fund for life. And then the last one, let's just be crazy. And we'll go aggressive. We'll go hyper-aggressive. We'll be 100% target date fund in the early years, because remember, there wasn't enough risk there. So let's see if this just pushes us over the edge.

And we'll ramp that down to 20% in retirement, because it might improve the safe withdrawal rates in retirement. And let's see how those did. So if we take a look at it, what we see is that the target date fund is-- these are the 1928 numbers. It's going to potentially make you tolerate a 65% drawdown, but it's going to give you a very solid 8.5% rate of return for that.

And it's going to have the diversification we expect, just credit, term, and market. This easy strategy gives you about an extra 1% in return, slight increase in the drawdown, a little bit of a bump in the drawdown towards retirement. That's not ideal, but a much more diversified portfolio down here in terms of the attributes the portfolio is firing on.

And then the moderate one, the moderate two-fund-for-life, is about the same return, but it tames the risk out here by retirement. So this is lower, and it brings some of that risk into the early years. And interestingly, it's not as diversified. Why is it not as diversified? I mean, we've got that 100% allocation to small in value in the early years.

Well, the reason it's not as well diversified is there aren't as many dollars in those early years. So even though it sounds extreme to pull the asset allocation up in the early years, you're not taking a risk with a huge amount of dollars. So it doesn't tilt it that much.

And then the most aggressive one over here, obviously the highest return, comes with the highest risk, but the highest amount of diversification. And I think that this is intriguing, but if I was a young person, what I'd really want to know is, how did they do at multiplying my buying power?

What's my real dollar benefit from doing this? And to do that, we need to calculate what I call a real dollar multiplier. And the way we'll do that is we will remove inflation to get the real future balances and the real contributions. And we will divide the real balance that we have at 40 years-- that's the inflation-adjusted real purchasing power-- by the total real contributions that we've made.

And when we do that, we get a really interesting set of numbers down here at the bottom. Every single one of these strategies did better than double your purchasing power across a 40-year period of accumulation across all of the time frames that we looked at. That was the worst.

They all did better than double. The place where they really differ is in upside. The target date fund gives you about an upside, the best-case scenario, of multiplying your purchasing power by about 5 and 1/2. The easy two funds for life is a little more than 7. The moderate two funds for life was almost 8.

And the aggressive strategy was about 14. So the averages are between the two. And the medians, or the expected values, are between the two. So each of these strategies, as it takes more risk, is likely leading to you having more purchasing power later in life, which I think is powerful.

So that covered accumulation. But what about retirement? To do retirement, we're going to use a different multiplier. We're going to look at the nest egg multiplier, which is the real withdrawals plus the real end balance divided by the initial nest egg. So that's all the money you get to spend in retirement plus pass on to errors divided by the initial nest egg.

And what we see here is that, again, there's this growing increase between-- by the way, I've combined the target date fund and moderate in this column because they're the same thing. They're all 100% target date fund in retirement. So that's about a 7.2 CAGR. The easy one is about a 7.7 CAGR.

The aggressive is about 8.7. And because the aggressive is tilting us more towards the US, I added another aggressive over here that includes a mix of US and international small cap value. And it performed a little bit more poorly, but is better balanced in terms of its geography. The scary part, though, most of you who are watching have probably already picked up on it, is that these ran out of money in retirement.

Now, this is a 40-year retirement, so it's a long time of 4% withdrawals. They all, at some point from 1928 to 2021, on one of those scenarios, ran out of money. But what's more meaningful is probably their survival rates. And that's right here. And they all did pretty well.

So the target date fund had a 99% survival rate for 30 years and an 88% survival rate for 40 years. As we go across the chart, they get better. The easy-to fund for life was 97%, roughly, in terms of the 40-year safe withdrawal rate -- or, I mean, survival rate.

And the aggressives both had practically 100%. And down at the bottom, if we look at their safe withdrawal rates, the best safe withdrawal rates -- actually, the aggressive strategy. So, again, as a retiree, I would encourage you to hold some small-cap value because it's going to boost the resilience of your portfolio.

And the multipliers are down here at the bottom. The worst, 1.1, is for the target date fund, but they're all about the same -- 1.1, 1.2. And the upside benefit just comes with more tilt towards the more volatile assets of small-in-value. So the final topic, what do we give up by being simple?

Well, I've analyzed a very complicated Merriman target-date portfolio using 13 asset classes. That's over on the right. And a two-fund-for-life aggressive strategy. And the answer is not much. The two-fund-for-life aggressive actually had the higher return, very slight. I'd say that for all intents and purposes, they're the same. But what this says is with two funds, you could do almost everything you can do with 13, and it's much, much easier to manage.

There are things that we give up, though, some real things. And the most important one is probably tax efficiency. When you bundle your equities and your bonds together in a single fund, you can't -- if they're all in a tax-deferred fund, a Roth IRA or a 401(k), you're fine.

But if they're in a taxable account, you'd really like to separate out the bonds and put them in the tax-deferred account. So that's a cost to simplicity. You can't do the account location as precisely. You also can't control individual attributes of the portfolio as precisely. You don't have independent control over the U.S.

international small/large value growth splits. You lose some regret avoidance. You know, if large-cap blend is the hot thing last year, if it had the best return, you don't hold that fund, and you might regret that. So that's an issue. And then personal preference. Some people just like the complexity.

So in summary, simple, balanced portfolios can broadly diversify across companies, countries, factors, age, and they can improve the likely return per drawdown risk in accumulation and improve your safe withdrawal rates and survival rates and resiliency and end balances in retirement. But they do give these few things up -- customization, tax efficiency, the chance to always own what's hot, and the chance to be with the herd.

So I'd encourage you to look for more on our website, to sign up for the newsletter and get Paul and Rich's excellent book, "We're Talking Millions." And if you want the deep dive into Two Funds for Life, buy my book, "All the Profits Go to the Foundation." And just a quick disclaimer, everything in this presentation is informational.

I can't be your advisor, and I'm sure it has some mistakes, so no... ♪♪ ♪♪