Bogleheads® Chapter Series - Chris Pedersen on Simple & Effective Balanced Lifetime Portfolios- 2022
00:00:00.000 | (upbeat music)
00:00:01.740 | - Welcome to the "Bogleheads Chapter Series."
00:00:04.540 | This episode was hosted
00:00:05.880 | by the Metro Boston Bogleheads Chapter
00:00:08.240 | and recorded April 23rd, 2022.
00:00:11.620 | It features Chris Pedersen
00:00:13.080 | of the Merriman Financial Education Foundation
00:00:15.920 | discussing several simple and effective portfolios
00:00:18.820 | which offer massive diversification appropriate
00:00:21.240 | for both accumulation and retirement stages.
00:00:23.860 | Bogleheads are investors
00:00:25.780 | who follow John Bogle's investing philosophy
00:00:28.020 | for attaining financial independence.
00:00:30.520 | This recording is for informational purposes only
00:00:32.860 | and should not be construed
00:00:33.900 | as personalized investment advice.
00:00:35.900 | - We're fortunate enough to have Chris Pedersen
00:00:42.060 | from the West Coast with us here today.
00:00:44.580 | And Chris volunteers
00:00:45.740 | at the Merriman Financial Education Foundation,
00:00:49.040 | a nonprofit run by Paul Merriman
00:00:51.420 | with the goal of providing financial education
00:00:53.940 | and tools to investors to make informed decisions.
00:00:57.680 | For several years,
00:00:58.540 | I've been listening to the Paul Merriman's podcast
00:01:01.980 | and I heard about Chris's research.
00:01:04.380 | A few months ago,
00:01:05.220 | I watched a presentation Chris did in 2020
00:01:08.620 | on the topic he's gonna speak about today.
00:01:11.020 | And I was impressed by the research
00:01:12.780 | that Chris and the Merriman Foundation have done
00:01:15.860 | and also how Chris can take complicated data analysis
00:01:19.460 | and explain it in a clear, concise way.
00:01:22.400 | Chris, I thought I'd start by asking you a few questions
00:01:26.580 | so our audience can get to know more about you.
00:01:29.460 | - Sounds good.
00:01:30.580 | - Okay.
00:01:31.980 | You were an engineer working in Silicon Valley
00:01:34.220 | until you retired.
00:01:35.500 | How did you meet Paul Merriman
00:01:37.060 | and how did you get involved with the Merriman Foundation?
00:01:39.960 | - Well, I was an engineer in Silicon Valley
00:01:43.700 | and I was, you know how you get that kind of spidey sense
00:01:47.020 | that maybe a change is coming
00:01:48.700 | and maybe retirement is coming.
00:01:50.220 | I kind of thought that was what was in my near future.
00:01:52.940 | And I knew that that meant
00:01:55.860 | I needed to become a better investor.
00:01:57.660 | So I started listening to podcasts, reading lots of books.
00:02:00.900 | And I was like you,
00:02:02.160 | I was impressed with the work that Paul did.
00:02:05.220 | He just didn't have any conflict of interest.
00:02:08.040 | He was motivated by one thing, to help people.
00:02:10.980 | And so I thought, well, if I could reach out to him,
00:02:14.180 | maybe I could volunteer.
00:02:15.440 | That was something my mom always did.
00:02:16.980 | She volunteered to work with all kinds of impressive people.
00:02:20.020 | And to my surprise, Paul said, yes.
00:02:23.980 | He said, I've got some cool projects,
00:02:25.980 | you know, would you want to work?
00:02:27.380 | And it was like, great.
00:02:28.220 | So I started working with him
00:02:29.820 | and that gave me access to a huge amount of data
00:02:33.980 | and research and perspective and more than anything,
00:02:38.520 | the opportunity to try to teach things I was learning
00:02:42.900 | because you always learn better when you try to teach.
00:02:46.060 | So that was how I got started.
00:02:47.500 | I mean, it was really just a phone call.
00:02:49.940 | - Okay, great.
00:02:51.300 | And can you tell us a little bit more
00:02:52.820 | as director of research about, you know,
00:02:55.340 | the research and the work that you do
00:02:57.200 | at the Merriman Foundation?
00:02:58.900 | - Yeah, we, you know,
00:03:01.340 | we try to essentially become time travelers.
00:03:05.660 | We have return sequences that go back to anything
00:03:09.460 | from the 1990s to about 1928.
00:03:13.280 | And sometimes there are gaps in those return sequences
00:03:17.280 | that we have to fill in.
00:03:18.400 | So we get, you know, we do the very best we can
00:03:21.700 | leveraging all the various data sources
00:03:23.520 | we can find to do that.
00:03:25.940 | And then when we have those return sequences
00:03:28.940 | for different asset classes going back into the past,
00:03:32.380 | we think about interesting investor questions like,
00:03:35.260 | you know, does it make sense to rebalance
00:03:37.340 | more or less frequently?
00:03:38.740 | Does it make sense to just invest in the S&P 500
00:03:42.780 | or diversify more broadly?
00:03:45.140 | And we had, up until I joined the organization,
00:03:47.940 | all of our work was with fixed allocations,
00:03:50.500 | but I wanted to do some work with target date funds,
00:03:53.760 | which have time varying allocations.
00:03:55.860 | So a lot of what I do is building back testers
00:03:59.780 | that will take a time varying asset allocation
00:04:03.540 | across a lifetime and a number of assumptions
00:04:05.900 | about how somebody's cash flows look
00:04:08.680 | and figure out how it would have performed in the past.
00:04:12.700 | There's no guarantee the future will be like the past,
00:04:15.140 | but we have no way to know what the future would be at all
00:04:18.340 | unless we base it on something in the past
00:04:21.540 | is the best predictor we've got.
00:04:23.060 | So it's fun.
00:04:24.820 | We work with a lot of really interesting questions
00:04:27.740 | and we get a lot of interest.
00:04:28.740 | I'm hoping to get some interesting questions
00:04:30.660 | at the end of the presentation today.
00:04:32.300 | And I learn as much from those as I do
00:04:34.540 | from the work I do with Paul.
00:04:36.420 | - Okay, great.
00:04:37.380 | Well, now that we know a little bit about you
00:04:39.180 | and your background, I'm gonna turn it over to you.
00:04:42.220 | So go ahead and start.
00:04:44.820 | - Let me see if we can get this sharing set up right.
00:04:47.580 | - One thing, Therese, is that the saving of the chat
00:05:00.300 | would be at the end of the presentation.
00:05:03.620 | If they save it now.
00:05:05.220 | - Are you seeing the presenter view
00:05:06.620 | or are you seeing the presentation?
00:05:09.100 | - We're seeing the presentation.
00:05:10.660 | - Okay. - Excellent, okay.
00:05:12.260 | So, man, I can't believe it's been two years
00:05:15.140 | since I first did this presentation.
00:05:16.820 | And I hope that this new version can live up
00:05:19.940 | to the kind introduction Therese gave me.
00:05:22.220 | When we did this two years ago,
00:05:25.780 | one of the criticisms I got
00:05:27.220 | was that our analysis only went back to 1970.
00:05:30.180 | So today I'm going to be doing some analyses
00:05:32.900 | that go back to 1970,
00:05:34.140 | but we're gonna extend where we can back to 1928.
00:05:38.540 | And that'll give us a scarier picture
00:05:41.540 | because it includes the great depression,
00:05:43.580 | but it'll also give us a more realistic picture
00:05:46.060 | because from 1970 until now
00:05:48.820 | was a relatively strong market for bonds.
00:05:52.540 | And by going back to 1928,
00:05:55.180 | we'll include the good news, the bad news,
00:05:57.260 | and everything in between.
00:05:58.340 | And I think it'll give us more confidence
00:06:00.660 | about the conclusions.
00:06:02.220 | So we're gonna talk about simple and effective
00:06:04.180 | balanced lifetime portfolios.
00:06:06.660 | And before we get started,
00:06:08.900 | because I'm talking to bogleheads,
00:06:10.540 | I have to mention the three best pieces of advice
00:06:13.980 | that I remember hearing Jack advocate.
00:06:17.500 | One was buy right.
00:06:18.660 | The second one was hold tight.
00:06:20.700 | And the third was don't peak.
00:06:22.340 | And I think in many respects,
00:06:24.420 | if you had to just give somebody six words,
00:06:26.580 | those were a wonderful set of six words for investing.
00:06:29.540 | The focus of today's presentation
00:06:33.860 | is mostly gonna be on buy right.
00:06:35.620 | And I know that for Jack Bogle,
00:06:38.460 | buy right meant the S&P 500 or a total market fund.
00:06:42.860 | And I really don't have anything against that.
00:06:46.260 | I think it's fine.
00:06:47.340 | I think it's great advice.
00:06:48.900 | And I think for people who aren't willing to learn more
00:06:52.380 | about investing and aren't willing to study it a little bit,
00:06:56.780 | it's probably the right place to stop.
00:06:58.540 | And that's probably why Jack stopped there.
00:07:01.300 | I think if you do have an appetite to learn more though,
00:07:04.500 | there are other opportunities
00:07:06.020 | for meaningful diversification
00:07:08.140 | that at least historically
00:07:10.060 | have had really significant advantages.
00:07:13.140 | So let's talk about what some of those are.
00:07:15.300 | When we talk about simple balanced portfolios,
00:07:19.060 | the reason I'm excited about it
00:07:20.500 | is that they give us an ability
00:07:22.540 | to control the return risk trade-off that we're gonna get.
00:07:26.460 | And sometimes even improve the return per unit of risk
00:07:30.060 | that we're taking.
00:07:31.780 | They give us the ability to have higher safe withdrawal rates
00:07:35.820 | or higher survival rates sometimes in retirement.
00:07:38.780 | At least that's what the history says.
00:07:40.900 | And they're easier to manage than 20 stocks or 50 funds.
00:07:45.900 | There's a lot of complex ways to get to the same place,
00:07:49.980 | but why be complex if you don't need to be?
00:07:52.300 | So we'll talk about the simple paths
00:07:54.060 | and then we'll talk about the trade-offs
00:07:55.820 | that we give up for that simplicity.
00:07:58.180 | What we'll cover today are first of all,
00:08:01.900 | what balanced portfolios are.
00:08:04.660 | Second of all, what we can do with a few funds
00:08:07.660 | in a fixed allocation.
00:08:09.060 | And then third, what we can do with a few funds
00:08:11.420 | in a time varying allocation, like a target date fund.
00:08:15.420 | And we'll in each case,
00:08:17.140 | look at how they differed during accumulation
00:08:19.740 | and during retirement,
00:08:21.420 | because those are dramatically different phases of life
00:08:24.220 | and they have different priorities.
00:08:27.620 | And finally, we'll talk about what we give up
00:08:29.620 | by being simple and hopefully have time
00:08:31.420 | for question and answer.
00:08:34.460 | So balanced, let's just start with the word.
00:08:36.940 | What does balanced mean?
00:08:38.100 | Most of us have ridden a bicycle,
00:08:39.940 | so you know about left and right and staying balanced.
00:08:43.100 | And so one definition is an even distribution of weight,
00:08:47.180 | enabling someone or something to remain upright and steady.
00:08:51.380 | A second definition, which starts to get closer
00:08:53.820 | to what we're gonna talk about today,
00:08:55.260 | is a condition in which different elements are equal
00:08:58.860 | or in the correct proportions.
00:09:01.660 | And then the third and most specific to investing
00:09:05.020 | would be an investment strategy,
00:09:06.900 | which balances risk and return
00:09:09.300 | by combining different assets, such as stocks and bonds.
00:09:13.020 | And we'll look at all of those,
00:09:15.140 | but let's start just to kind of get our minds going.
00:09:17.900 | Let's start out of category.
00:09:19.540 | Let's start with something I'm very passionate about,
00:09:22.580 | perhaps even more than investing, food.
00:09:25.820 | So balanced flavors.
00:09:28.260 | If you were to start thinking about
00:09:31.060 | trying to be a great chef,
00:09:32.540 | you'd probably have on your mind the idea
00:09:34.340 | that you need to balance flavors.
00:09:35.980 | And you would probably think of the world,
00:09:38.860 | at least I do, like this.
00:09:41.300 | There's tens of thousands of ingredients.
00:09:43.420 | There's tomatoes and chickpeas and onions
00:09:46.420 | and steak and cereal.
00:09:48.900 | How do I balance them all?
00:09:50.860 | And the good news is that through science
00:09:55.660 | over the course of the last 100 years,
00:09:57.820 | chefs have come to realize
00:10:00.020 | that there are six underlying key attributes
00:10:04.260 | and that foods kind of cluster in these key attributes.
00:10:07.260 | And those are spicy, sour, sweet, salty, umami, and bitter.
00:10:11.900 | And that some of these attributes balance one another
00:10:15.700 | and some of them compliment one another.
00:10:18.220 | And that you can make fantastically tasty meals
00:10:22.100 | by properly selecting among them and combining them.
00:10:26.020 | And that the best things are usually a combination,
00:10:28.700 | not just one note, not just salty, not just sweet.
00:10:32.900 | Although many of the fast foods we eat are just that.
00:10:36.460 | But the best foods,
00:10:37.540 | the meals that we probably remember the most
00:10:39.660 | are usually an artful combination of all of these.
00:10:42.660 | Well, it turns out you can look at investing
00:10:44.420 | much the same way.
00:10:45.460 | If we look out at the kinds of stocks
00:10:48.860 | or companies we could invest in in the world,
00:10:51.900 | there are thousands, thousands and thousands of companies
00:10:55.500 | and trying to figure out how you would choose among them
00:10:58.820 | and why you would choose certain ones over other ones
00:11:01.620 | and which ones might compliment one another
00:11:04.060 | or which ones might balance one another
00:11:06.500 | is a very difficult task.
00:11:08.020 | But fortunately for us,
00:11:10.300 | academics have done an exercise
00:11:12.100 | much like the food scientists did
00:11:14.860 | and have figured out that there are key attributes
00:11:17.180 | both in the fixed income or bond space
00:11:19.780 | and in the equity or stock space.
00:11:22.300 | So in the fixed income or bond space,
00:11:24.340 | there are basically two attributes that really matter.
00:11:27.340 | One is the length of the bond or the term.
00:11:30.500 | And you can imagine if you are gonna,
00:11:34.340 | if you think of the bond as a loan,
00:11:36.020 | if somebody is gonna loan you money
00:11:37.980 | or you're gonna loan somebody money and buy a bond
00:11:40.660 | for one year, you would probably accept a smaller return
00:11:45.500 | or interest rate than if you loaned the money for 20 years.
00:11:48.340 | 'Cause who knows what's gonna happen
00:11:49.660 | with inflation over 20 years.
00:11:51.140 | So the longer the term
00:11:53.940 | or the longer the duration of the bond,
00:11:56.500 | the more you're gonna ask for
00:11:57.900 | in terms of a return in interest
00:11:59.540 | and you're likely gonna get it.
00:12:01.940 | Credit's a similar kind of thing.
00:12:04.100 | If you loan the federal government
00:12:05.780 | in the United States money,
00:12:07.060 | they can print money and give it back to you.
00:12:08.740 | You're gonna get paid back.
00:12:10.100 | The money may not be worth quite as much,
00:12:12.180 | but they could do that.
00:12:14.260 | If you loan money to a fly-by-night business
00:12:17.140 | that's on the verge of bankruptcy,
00:12:18.580 | you're gonna ask extortionist rates and you might get it.
00:12:22.420 | And so in bonds, these two attributes, term and credit,
00:12:26.580 | pretty much define about 98 to 99%
00:12:30.460 | of the return experience you're gonna get
00:12:32.740 | in terms of the volatility
00:12:34.220 | and the compound annual growth rates.
00:12:36.940 | In stocks or equities, there are five attributes
00:12:40.940 | that the academics have found and generally agree upon.
00:12:44.500 | The first is market risk.
00:12:45.940 | And that's the idea that by investing in the stock market,
00:12:49.700 | you're going to see the value of your money
00:12:52.420 | or your investment go up and down
00:12:54.460 | as all kinds of unknowns come to pass.
00:12:57.780 | Earnings go up and down.
00:12:59.500 | The economy changes.
00:13:01.580 | There's geopolitical news.
00:13:03.900 | And so you're going to expect to be compensated for that.
00:13:06.780 | And historically, if you invested in the S&P 500
00:13:09.940 | or a total market fund, you were.
00:13:12.460 | You were compensated for that.
00:13:13.940 | You got a return of between 6% real and 10% nominal.
00:13:18.940 | So you get a return.
00:13:24.860 | The second one is size.
00:13:26.980 | Smaller companies tend to be more volatile.
00:13:29.140 | So investors tend to expect to and get a higher return
00:13:34.140 | out of investing in smaller companies.
00:13:36.380 | Not always, but they tend to,
00:13:39.060 | and particularly higher quality smaller companies.
00:13:42.180 | And we'll take a look at that in a minute.
00:13:44.740 | Value is the third characteristic.
00:13:47.060 | And this basically says that if you buy parts of the market
00:13:50.340 | that are out of favor, they're not inflated in price,
00:13:54.500 | you're going to have a kind of a buffer,
00:13:56.900 | a cushion, if you will, a margin of safety
00:14:00.020 | that potentially will deliver you a higher return
00:14:02.700 | in the future.
00:14:03.540 | And historically has delivered a higher return.
00:14:05.900 | The next two qualities are momentum
00:14:10.100 | and the quality attribute or factor.
00:14:13.420 | And momentum basically says things that have been going up
00:14:16.380 | continue to go up until they don't.
00:14:19.060 | So the trick with momentum is that,
00:14:20.820 | although the companies that have been going up
00:14:24.740 | tend to continue going up, you have to keep watching them.
00:14:27.620 | And when they start to go down,
00:14:28.820 | if they go down for a certain amount of time,
00:14:30.340 | you have to trade out of them.
00:14:31.340 | So momentum is a more active strategy.
00:14:34.740 | And then quality says companies that have better financials
00:14:38.380 | or better moats to defend against competition do better.
00:14:41.940 | So this is all kind of airy-fairy and fuzzy,
00:14:44.820 | but the key takeaway, if you back up to the 10,000 foot view
00:14:48.660 | is that in the same way that there are these attributes
00:14:51.300 | that drive a tasty meal,
00:14:53.660 | there are a handful of attributes
00:14:55.460 | that drive a high performance portfolio.
00:14:59.540 | And we're going to look at how they have actually done
00:15:01.780 | in the past and how they performed.
00:15:03.340 | But before we do that,
00:15:04.460 | let's look briefly at how available they are.
00:15:07.620 | So if we're looking for market risk,
00:15:10.500 | there are literally thousands of US stocks or funds
00:15:14.580 | that give us access to market risk.
00:15:17.620 | And what I've defined as meaningful access
00:15:20.140 | is greater than 30% of the premium
00:15:22.660 | that the academics have discovered.
00:15:24.260 | So pretty much every stock fund you could invest in,
00:15:28.420 | whether it's a mutual fund or an ETF,
00:15:30.460 | is going to give you exposure to the market risk
00:15:33.980 | that we just talked about.
00:15:35.860 | The size risk is available in 1,000 plus funds.
00:15:39.940 | The value risk is available in about 1,000 funds.
00:15:44.100 | You can get market size and value risk
00:15:47.620 | in about 500 funds in the United States.
00:15:50.820 | You can get market size value and quality risk
00:15:54.540 | in about 300 funds in the United States.
00:15:58.700 | So these would be called small cap value funds,
00:16:02.140 | and they are the original multi-factor fund.
00:16:05.100 | If you go out and look for multi-factor labeled funds,
00:16:07.940 | you won't find that many.
00:16:09.580 | But if you invested in a small cap value fund
00:16:12.620 | that also screens on quality,
00:16:15.300 | you're in a multi-factor fund.
00:16:17.780 | And we'll see why that's important in a little bit.
00:16:21.020 | If you're looking for funds that deliver meaningful exposure
00:16:24.260 | to momentum and quality, they are rare.
00:16:27.100 | They're hard to come by.
00:16:28.540 | And it's because momentum is a costly attribute
00:16:33.340 | to get in the market and involves a lot of trading.
00:16:35.820 | There's inefficiency associated with that.
00:16:38.500 | And if you're looking for quality,
00:16:40.660 | too much of it's absorbed in these other funds.
00:16:44.260 | Everybody tries to screen on quality
00:16:46.460 | and the quality specific funds, there aren't that many.
00:16:49.660 | So if we're looking into somebody's kitchen,
00:16:54.300 | their 401k, they're trying to cook their portfolio.
00:16:57.260 | What do they have?
00:16:58.100 | What are their ingredients?
00:16:58.940 | Well, basically they have two staple ingredients.
00:17:01.620 | They have stock funds and they have bond funds.
00:17:04.020 | And almost every 401k or IRA is gonna have access to those.
00:17:08.500 | And then they have spices
00:17:09.860 | and there's a mild spice and a strong spice.
00:17:12.580 | You could have a large cap value fund.
00:17:14.540 | Many 401ks do.
00:17:16.900 | If you're lucky, you'll have a small cap value fund
00:17:19.740 | because that's a stronger spice.
00:17:21.380 | And as we'll see, working with the stronger spice
00:17:24.500 | is a better way to diversify because it's more different.
00:17:26.980 | It's more different than the fixed income.
00:17:29.620 | It's more different than the all stock portfolio.
00:17:32.860 | So if we were to look now at how they've performed
00:17:37.980 | in the past, do they do what I say, right?
00:17:40.660 | Do they, did they really, could you really buy this?
00:17:43.380 | That's another way to look at it.
00:17:44.860 | And did it really make a difference?
00:17:46.380 | And you can test this at PortfolioVisualizer.com.
00:17:50.420 | Tuomo runs a great site there.
00:17:52.220 | It's free and you can go back test asset allocations
00:17:56.740 | into all of these assets that are on the board,
00:18:00.060 | the value, the blend, the growth, the large,
00:18:02.180 | the mid and the small.
00:18:03.740 | And you can see how they've performed since 1972.
00:18:07.380 | And what you'll see, I got to grab a marker here,
00:18:11.580 | is that Large Cap Blend, let's see.
00:18:17.980 | Yeah, so Large Cap Blend has delivered
00:18:21.500 | about a 10.55% annual return.
00:18:25.220 | And interestingly, the total market has also delivered
00:18:29.180 | about a 10.55% rate of return.
00:18:33.500 | And it's come at a cost, if you will,
00:18:35.620 | a behavioral cost of tolerating a 51% worst drawdown.
00:18:40.180 | So you had to be willing to lose 50% of your money on paper,
00:18:44.580 | but if you stuck with it and you endured
00:18:47.660 | and you didn't bail when the market was down,
00:18:50.620 | you got the return of 10.55%, which isn't too bad.
00:18:53.780 | That's actually amazingly good.
00:18:56.300 | What's interesting is that the total market
00:18:59.260 | did about the same thing as Large Blend.
00:19:01.980 | Now, how can that be, right?
00:19:03.420 | How can it be that when I add in the mid caps
00:19:06.780 | and I add in the small caps and I add in the growth
00:19:10.020 | and I add in the value, I get the same return?
00:19:12.140 | Well, first of all, the mids and the small
00:19:15.380 | don't make up a lot of the market.
00:19:17.380 | The bulk of the market, 80 plus percentage of the market
00:19:20.860 | is in these large companies.
00:19:22.620 | So they just don't add a lot of weight.
00:19:25.220 | And then the other thing that's true
00:19:27.820 | is when you add the value and you add the growth,
00:19:30.260 | they cancel each other out.
00:19:31.500 | You don't have a tilt to either value or growth.
00:19:33.860 | You end up back at the same place you started.
00:19:35.780 | You end up with Blend.
00:19:37.580 | So this area, this Large Cap Blend that I've highlighted,
00:19:42.460 | that's essentially what you get with the S&P 500.
00:19:45.540 | It's also pretty close to what you get
00:19:47.180 | with the total market.
00:19:48.980 | Now, I said we have two spices we can spice things up with.
00:19:52.180 | If you come over here to Large Cap Value,
00:19:54.540 | you can see you get about 6/10 of a percent
00:19:57.340 | higher rate of return with a little bit higher volatility,
00:20:01.300 | about 4% more or worse drawdown that you had to tolerate.
00:20:06.620 | The drawdown is how much your balance declined from its peak
00:20:11.100 | or how much the account got smaller from its peak
00:20:13.420 | before it turned around and started coming back up.
00:20:16.220 | If you look down here in the bottom left, though,
00:20:18.260 | look at the strong spice.
00:20:20.780 | 13.94% was the compound rate of return.
00:20:25.220 | So that's over 3 percentage points, almost 3 and 1/2
00:20:28.300 | percentage points of compound annual rate of return
00:20:31.420 | benefit for spicing the portfolio
00:20:33.700 | or investing in the strong spice.
00:20:36.620 | And it came with a little bit more volatility.
00:20:39.420 | Now we're at 56% drawdown, but not much, not much.
00:20:42.780 | So the return per unit of risk in small cap value
00:20:46.500 | is actually the highest of anything on the chart.
00:20:49.180 | Interestingly, the worst return per unit of risk
00:20:52.180 | is in this bottom right-hand corner in small cap growth.
00:20:56.620 | So in some respects, there are two lessons here.
00:20:59.820 | One is you want to spice things with value and small.
00:21:03.260 | But the other is you want to avoid small cap growth.
00:21:06.500 | You want to avoid that part of the market that's
00:21:08.500 | in the bottom right-hand corner.
00:21:10.020 | And again, if you buy the whole market, you get them both,
00:21:12.420 | and they kind of cancel each other out.
00:21:15.180 | So let's take a look at what things
00:21:18.020 | look like without inflation.
00:21:20.020 | Let's look at real returns.
00:21:21.980 | And let's simplify it down to our three key ingredients.
00:21:25.900 | We've got bonds down here in the bottom left.
00:21:28.700 | We've got stocks up here in the middle.
00:21:30.500 | And we've got small cap value stocks
00:21:33.140 | over on the bottom right.
00:21:34.380 | And they kind of form a triangle of returns.
00:21:37.140 | And now we're looking at returns that
00:21:39.220 | are real, which means without the effects of inflation
00:21:43.380 | or with inflation removed.
00:21:44.740 | So we can see how our buying power is increasing.
00:21:48.100 | And what you see is that the compound annual growth
00:21:51.180 | rate for bonds--
00:21:52.420 | this is intermediate term government bonds--
00:21:54.820 | is very low.
00:21:55.780 | It's about 2%.
00:21:57.180 | And not surprisingly, that doesn't
00:21:59.380 | enable you to take much out safely in retirement.
00:22:01.820 | It only has a 40-year safe withdrawal rate
00:22:04.020 | of a little bit less than 2%.
00:22:06.780 | But it's very safe, only minus 9%, worst case drawdown.
00:22:12.060 | If you look at stocks, now we're talking
00:22:14.580 | about a meaningful engine to drive good returns.
00:22:17.660 | You get 6.8% going back to 1928.
00:22:20.820 | That was the median compound annual growth rate
00:22:24.540 | after taking out inflation.
00:22:26.100 | That's really strong.
00:22:27.500 | But you had to tolerate a worst case drawdown of 83%.
00:22:31.660 | And it generated a 3% safe withdrawal rate.
00:22:35.740 | It's better on safe withdrawal rate, but worse on drawdowns.
00:22:39.700 | And if we look at small cap value,
00:22:41.620 | obviously the highest compound rate of return,
00:22:44.060 | but also the worst drawdown.
00:22:47.620 | And interestingly, not the best safe withdrawal rate either.
00:22:53.620 | The best safe withdrawal rate on this chart is right up here.
00:22:57.060 | It's for all stocks.
00:22:59.500 | So does that mean we should just be all stocks in retirement?
00:23:02.500 | Well, we haven't looked at what happens
00:23:04.180 | when you combine these.
00:23:05.140 | Let's take a look at the combinations.
00:23:06.940 | So if we look at the middle of each side--
00:23:09.900 | so that would be a 50/50 combination of stocks and bonds,
00:23:15.180 | or a 50/50 combination of stocks and small cap value,
00:23:18.500 | or a 50/50 combination of bonds and small cap value--
00:23:22.420 | the highest safe withdrawal rate is actually
00:23:24.860 | down here on the bottom now, which
00:23:27.820 | is starting to speak to this idea
00:23:30.300 | that depending on the meal you want to eat,
00:23:33.420 | the ingredients that you use may vary.
00:23:36.860 | If you want the safest retirement portfolio out
00:23:40.900 | of these combinations, it would probably
00:23:42.900 | be this one at the bottom.
00:23:45.700 | It doesn't have the lowest drawdown.
00:23:48.740 | It's got a drawdown of 60% out of the ones on the sides.
00:23:52.700 | But it's got a really strong compound rate of return at 6.8%.
00:23:56.700 | If you want the lowest drawdown out of these 50/50 combos,
00:24:00.900 | it's right over here.
00:24:01.780 | It's the combination of 50% bonds and 50% stocks.
00:24:07.340 | These are US stocks, by the way, going back to 1928.
00:24:11.060 | And if you want the highest rate of return, it's over here.
00:24:14.100 | It's the combination of the 50% stocks and 50% small cap value.
00:24:20.140 | So we're starting to play around with mixing this up.
00:24:24.300 | And if you want all the gory details,
00:24:26.540 | if you want to see all the 10% changes,
00:24:29.060 | I've got it going back to 1928 and 1970.
00:24:32.020 | This is out of my book, Two Funds for Life.
00:24:35.060 | I'm not going to spend any time on those.
00:24:36.860 | They're just too complex for this.
00:24:38.260 | But I will make the point that the highest safe withdrawal
00:24:41.420 | rates always come from a combination of these asset
00:24:44.260 | classes, not from the extremes.
00:24:47.780 | And I think that leads nicely into this idea
00:24:51.060 | of a balanced portfolio, having a little bit
00:24:53.900 | of a lot of different things rather than all one.
00:24:57.500 | So some of you, if you're still with me,
00:25:00.060 | are probably thinking, but I don't want to cook, right?
00:25:02.820 | I don't want to be combining all these ingredients.
00:25:05.740 | Just give me the fast food meal or give me
00:25:07.580 | the microwave dinner.
00:25:08.980 | And we can do that.
00:25:10.220 | We can talk about some microwave dinners, some really easy ways
00:25:13.820 | to get things done.
00:25:14.700 | And in fact, most of the rest of the presentation,
00:25:16.980 | we'll talk about that.
00:25:18.380 | And there are two categories that I
00:25:21.380 | think are really interesting.
00:25:23.260 | The first is a set of funds called balanced funds.
00:25:25.940 | You can get them from Vanguard in their life strategy funds.
00:25:28.740 | You can get them from a lot of other providers as well.
00:25:31.860 | And the second is something called a target-based fund.
00:25:34.580 | And many of you are probably familiar with it.
00:25:36.820 | And whether you use it or not, you almost certainly
00:25:39.020 | know somebody who does because they're
00:25:40.540 | the default for a lot of new 401(k) programs for employers.
00:25:45.660 | Let's start by looking at these life strategy
00:25:48.060 | funds with fixed allocations.
00:25:50.340 | And we'll start by looking at the Vanguard life strategy
00:25:53.620 | funds.
00:25:54.780 | I've pulled up four of them here.
00:25:57.860 | And they go from a 20% stock, 80% bond allocation
00:26:02.100 | to an 80% stock, 20% bond allocation.
00:26:05.700 | And the way Vanguard describes them
00:26:08.420 | is they go from low to moderate, to moderate, to moderate
00:26:11.860 | to high, to high risk.
00:26:14.820 | That's their definitions.
00:26:17.500 | They're all a balance that tilts a little bit more
00:26:20.500 | towards the US, like 60% US, 40% international.
00:26:24.900 | But we can run the back tests and see
00:26:27.460 | how they did historically.
00:26:29.220 | And what we see, not surprisingly,
00:26:31.220 | is that as we add stock, we go from a 6.4% median compound
00:26:37.620 | annual rate of return to 7.6% to 8.6% to 9.3%.
00:26:42.900 | It's a pretty steady 1% increase with each step up
00:26:47.180 | in how aggressive we're being.
00:26:49.340 | But look what happened to the drawdown risk.
00:26:52.300 | You had to take a lot more risk or tolerate a lot more
00:26:55.780 | volatility to get it.
00:26:57.300 | This 2080 fund had a 20% worst case drawdown.
00:27:01.780 | That's not bad.
00:27:03.420 | The 4060, even though it only gives you
00:27:05.740 | 1% higher compound annual rate of return,
00:27:08.740 | had almost twice the drawdown risk.
00:27:12.060 | And the 6040 was 54%.
00:27:14.940 | And the 8020 was 66%.
00:27:19.220 | So these higher returns accumulate over time.
00:27:23.340 | But somewhere along the way, you're
00:27:25.020 | going to have to have conviction to tolerate a much bumpier ride
00:27:29.500 | to get it.
00:27:30.460 | Now, these numbers go back to 1928.
00:27:33.180 | If I went back to 1970, they'd be maybe 2/3 the size.
00:27:36.980 | So your ride may not be that bad.
00:27:39.100 | But it's nice to know it could be, just so that you're
00:27:42.460 | ready and ready to stick with whatever
00:27:44.660 | investment it is you pick.
00:27:47.540 | We can also look inside these portfolios
00:27:50.380 | and see which of those key attributes they're firing on.
00:27:55.180 | And all of these funds fire only on three.
00:27:58.420 | They fire on the market risk, the term risk,
00:28:00.900 | and the credit risk.
00:28:01.740 | That's it, just three.
00:28:04.020 | We can also look and see what their safe withdrawal rates
00:28:06.540 | are.
00:28:07.340 | And kind of interesting, if we look at the safe withdrawal
00:28:10.660 | rates, they increase across the board.
00:28:12.500 | The highest is over here with the portfolio that
00:28:15.700 | has the bumpiest ride.
00:28:17.060 | It has the biggest drawdowns.
00:28:18.820 | But it also has the highest safe withdrawal rate.
00:28:21.420 | So I think the key takeaway here for a retiree
00:28:24.700 | is that it makes sense to keep your equity engine alive.
00:28:28.700 | Don't get too conservative in retirement,
00:28:31.020 | especially if you need a higher withdrawal rate.
00:28:33.700 | Because having a portfolio that can't withstand whatever
00:28:38.180 | withdrawal rate you need increases your risk
00:28:41.780 | of running out of money or falling
00:28:43.220 | on a bad sequence of returns that basically put you
00:28:46.980 | out of business.
00:28:48.740 | So that was a set of things you can do with one fund.
00:28:53.940 | All of those are just one fund.
00:28:56.020 | But they all fire on only three of these attributes.
00:28:59.460 | What would happen if we brought in some more of the attributes,
00:29:02.500 | if we spiced it up a little bit?
00:29:05.140 | Well, why would we want to spice it up?
00:29:07.300 | If you go and take a look at Andrew Birkin and Larry
00:29:10.980 | Suedro's excellent book, Your Complete Guide
00:29:13.300 | to Factor-Based Investing, one of the really interesting
00:29:16.540 | things you'll learn is that factors
00:29:18.740 | tend to show up at different times in the market.
00:29:21.900 | So that means that when one's going up,
00:29:24.700 | the other one might be going down.
00:29:26.100 | Or when one's going up a lot, the other one
00:29:27.940 | might be going up a little.
00:29:29.300 | And we kind of knew intuitively, when
00:29:31.140 | you combine things that zig and zag at different times,
00:29:34.380 | you have the potential to smooth the ride.
00:29:36.820 | And a multi-factor portfolio, or one
00:29:39.940 | that fires on more of these attributes,
00:29:42.660 | tends to disappoint less often.
00:29:44.540 | And you can see that over here on the right.
00:29:46.580 | A market-only fund, that would be like a total market or S&P
00:29:50.380 | 500 fund, at five years has about an 18% chance
00:29:55.260 | of not delivering the return that you expect.
00:29:59.380 | In contrast, at five years, a fund
00:30:02.500 | that has exposure to market, size, value, and momentum
00:30:08.220 | has about a 5% chance of underperforming.
00:30:11.580 | So the difference there is pretty dramatic.
00:30:14.780 | You're talking about a factor of three increase in the likelihood
00:30:20.020 | that you're going to get the return that you expect.
00:30:22.140 | I think most of us would like that.
00:30:23.540 | We'd kind of like to have more predictable performance.
00:30:27.100 | So let's take those two of the two funds we looked at,
00:30:30.420 | or the four funds we looked at earlier.
00:30:32.860 | Let's look at the Vanguard Life Strategy 60/40
00:30:36.540 | and the Vanguard Life Strategy 80/20.
00:30:38.900 | We've already analyzed those.
00:30:40.500 | And let's slide something in between.
00:30:42.940 | A 60% stock for--
00:30:44.540 | Chris, you've muted yourself.
00:30:55.140 | [AUDIO OUT]
00:30:58.620 | How long have I been muted?
00:31:13.060 | You muted right about when you first
00:31:15.300 | started with the 60/40 Vanguard Life Strategy fund,
00:31:18.820 | and you added your spices.
00:31:20.740 | Excellent.
00:31:21.420 | OK.
00:31:22.180 | Well, thank you for telling me.
00:31:23.500 | Sorry, I have no idea how that happened,
00:31:25.620 | but I'm glad we're back.
00:31:28.020 | OK, well, so what I've done here on this chart
00:31:32.500 | is we've brought back the same analysis we had before
00:31:35.620 | with the 60/40 stock bond, Vanguard Life Strategy,
00:31:39.060 | and the 80/20.
00:31:40.660 | And we've slid something in between, which is a 60/40.
00:31:43.620 | So it's the same equity bond mix of the fund on the left.
00:31:49.300 | But we've done it with 35% US small cap value and 25%
00:31:53.740 | international small cap value.
00:31:56.100 | And the interesting thing is that we
00:31:58.340 | get a much higher compound annual rate of return
00:32:02.420 | than we do with the other 60/40.
00:32:05.260 | Not surprisingly, I guess.
00:32:06.740 | We took more risk.
00:32:07.860 | We added in this volatile class, our spicy mix of small cap
00:32:12.300 | value.
00:32:13.540 | But the drawdown, the worst case drawdown, only went up by 5%.
00:32:18.340 | So our return per unit of risk is much higher.
00:32:21.780 | And interestingly, our return is also
00:32:25.260 | higher than the 80/20 would have been had we just
00:32:28.260 | gone with the Vanguard fund.
00:32:30.060 | And our drawdown is better than the 80/20 would have been.
00:32:34.020 | And why is that?
00:32:35.460 | It's because of this diversification down here.
00:32:38.900 | We have far more working for us.
00:32:42.300 | We have the market exposure.
00:32:43.900 | We have the term and the credit exposure.
00:32:45.860 | But we also have value and size working for us.
00:32:48.980 | So it's a multi-factor kind of approach,
00:32:51.860 | even though we're just doing it with small cap
00:32:53.980 | value and total bond funds.
00:32:56.540 | The safe withdrawal rates also went up.
00:32:58.900 | The highest safe withdrawal rates are with this--
00:33:01.620 | it seems like kind of an extreme allocation
00:33:04.060 | because it's heavy on small cap value.
00:33:06.780 | Would I recommend that a retiree invest in this portfolio?
00:33:10.420 | No.
00:33:10.940 | But as a teaching moment, I think
00:33:12.740 | I would point out that it might benefit them
00:33:15.380 | to have some in small cap value because it's
00:33:18.940 | going to improve their return per unit of risk,
00:33:21.260 | and it's going to improve their resiliency in retirement.
00:33:26.420 | So with that, that's kind of our fixed allocations.
00:33:31.100 | Let's take a look at time-varying allocations.
00:33:34.780 | And to set this up, first of all,
00:33:38.020 | we have to think about, well, why do we change our asset
00:33:40.420 | allocations over time?
00:33:42.220 | Why would we not just have the same asset allocation
00:33:44.740 | our whole lifetime?
00:33:45.620 | And some people do.
00:33:47.580 | Some people have the temperament to be
00:33:49.140 | stocks their entire life.
00:33:51.060 | And that may work fine for them, but it's not
00:33:56.460 | in line with what most people would describe as our risk
00:34:00.180 | capacity as we go through life.
00:34:02.900 | I think a stock allocation that's 100% through life
00:34:05.780 | works primarily for somebody who's an over-saver
00:34:08.900 | and who has incredible behavioral skills
00:34:12.180 | as an investor, the ability to ignore the ups and downs
00:34:15.540 | of the market.
00:34:16.580 | But for most of us, especially those of us
00:34:20.260 | who are going to be just enough savers,
00:34:23.380 | it's really important to understand that our risk
00:34:26.020 | profile changes with time.
00:34:28.260 | When we're young, when we're over here
00:34:30.420 | in this early part of the chart on the left-hand side
00:34:32.940 | around age 25, if we lost our whole net worth,
00:34:36.780 | we've still got a lifetime to work to earn it back.
00:34:39.940 | We have 40 years probably of career
00:34:42.940 | for earning and letting not just our work earn us money,
00:34:48.020 | but letting the market earn us money as well
00:34:50.260 | through compounding.
00:34:51.780 | Halfway through our career, we've got a lot less.
00:34:54.140 | And when we're nearing 65, we're nearly done.
00:34:57.620 | Most of us are not going to be able to work another 20 or 30
00:35:00.660 | years at age 65, let alone want to.
00:35:05.020 | And so our risk capacity is declining with time.
00:35:10.020 | And our ability to have the market work for us
00:35:13.500 | is declining with time.
00:35:14.900 | It's only natural then that our portfolio risk would also
00:35:18.540 | decline with time.
00:35:19.820 | And the industry taking this into account
00:35:21.860 | has invented this amazing tool called a target date fund.
00:35:25.020 | You can get them from Vanguard now for 0.08%.
00:35:30.220 | So eight basis points gets you effectively a robo-advisor.
00:35:34.180 | And what it does--
00:35:35.700 | we'll talk about Vanguard specifically,
00:35:37.340 | but what they do in general in the market
00:35:39.900 | is they follow a path of decreasing allocation
00:35:44.700 | to equities and increasing allocation to bonds.
00:35:47.980 | And that's called a glide path.
00:35:50.540 | So this is an example of the industry average target
00:35:54.220 | the glide path on the right-hand side.
00:35:56.420 | And you can see that the equities are declining over
00:36:00.020 | time, and the bonds are increasing over time.
00:36:03.580 | And they do that not just to retirement,
00:36:06.300 | but through retirement.
00:36:07.700 | And if we looked at the Vanguard glide path--
00:36:10.220 | you can see it on the right here--
00:36:11.900 | you can see that they start ramping down
00:36:15.380 | about 40 years before retirement,
00:36:18.220 | and they ramp through to about seven years after retirement.
00:36:22.300 | And their early allocation is about 90% equities.
00:36:27.500 | And the way you use these, and the way a lot of new investors
00:36:30.580 | are defaulted into them, in fact, is by year.
00:36:34.580 | So if I was a new employee at a company,
00:36:38.700 | I'd probably get an email that said,
00:36:40.340 | we're going to invest 3% of your paycheck
00:36:42.460 | automatically into the--
00:36:45.020 | if I'm 25 years old and I've got 40 years to work--
00:36:48.580 | maybe it's the 2065 target date fund.
00:36:52.420 | And if I do nothing, that's what happens.
00:36:54.380 | I can increase it.
00:36:55.340 | I can change it.
00:36:56.140 | But a huge amount of today's assets in 401(k)s
00:37:01.820 | are in target date funds.
00:37:04.540 | And the question is, is that good?
00:37:06.620 | Is it good?
00:37:07.300 | And I think it's not good.
00:37:09.140 | I think it's wonderful.
00:37:10.380 | And the reason I think it's wonderful
00:37:12.460 | is that if we were to look at a lifetime investor who,
00:37:17.140 | on first chance, when they are faced with this 401(k) decision,
00:37:22.460 | says, I'm going to put 10% of my income
00:37:25.220 | into the target date fund.
00:37:26.980 | And they do that for 40 years of working.
00:37:30.620 | And then at the end of those 40 years,
00:37:33.100 | decide to take 4% out the first year
00:37:35.700 | and increase with inflation for 30 years of retirement.
00:37:39.300 | That 10% that they invested will turn into a pile of money
00:37:46.220 | that is much, much bigger than--
00:37:49.540 | well, not much, much bigger, but about the same size
00:37:51.700 | to a little bit bigger than everything
00:37:53.340 | they earned in real dollars.
00:37:55.300 | This is after adjusting for inflation in real dollars.
00:38:00.340 | And they'll have about half of it to spend in retirement
00:38:03.020 | and half of it as legacy.
00:38:05.340 | So just pause and think about that for a moment.
00:38:08.060 | This single investment, one tool that you can automate and put
00:38:12.500 | in the background for your entire lifetime
00:38:15.660 | can double the amount of spending power you have.
00:38:18.780 | I think it's just magical.
00:38:20.420 | It's an incredible tool.
00:38:22.100 | I don't think it's perfect, but I
00:38:24.220 | think it's designed for the masses,
00:38:26.420 | and it serves them well.
00:38:27.740 | And I think many, many people would
00:38:30.420 | be as well off doing this as 90% of the other choices
00:38:35.300 | that they're likely to make.
00:38:37.380 | So it looks like it works most of the time
00:38:40.860 | for most of the people.
00:38:42.300 | But does it do exactly what it says it does?
00:38:45.260 | Well, let's take a look.
00:38:47.060 | If you went back and looked at a lump sum investor
00:38:50.660 | and you analyzed all of the different months
00:38:52.980 | they could have started from--
00:38:54.420 | I'm only going to 1970 here, but January 1970, February 1970,
00:38:58.860 | all these different start months when
00:39:00.380 | their career might have begun.
00:39:02.620 | And you look at the worst case drawdown
00:39:05.260 | that might have been experienced across all of those lifetimes,
00:39:09.220 | you get this line down here at the bottom that goes across.
00:39:13.060 | And it shows that their worst risk exposure
00:39:16.900 | is in these early years from age 27, 28, something like that,
00:39:22.580 | through about age 40.
00:39:23.580 | And then it declines all the way out to retirement.
00:39:26.140 | It looks like it's doing exactly what it's supposed to do,
00:39:29.900 | but there's a problem.
00:39:31.140 | And the problem is that it's based on a lump sum investment.
00:39:34.900 | Almost no one starts with a lump sum investment
00:39:37.540 | saving for retirement.
00:39:38.740 | We generally start with practically nothing
00:39:41.540 | and contribute monthly.
00:39:43.300 | So what happens if we do monthly contributions?
00:39:46.220 | Well, now we get a totally different picture.
00:39:48.900 | Now we don't actually see much risk in these early years
00:39:52.340 | at all.
00:39:52.820 | In fact, we see a lot of wasted potential for taking risk.
00:39:57.020 | And the worst drawdown doesn't occur until age 40.
00:40:02.940 | It's about 42%.
00:40:04.500 | And yes, it does decline towards retirement.
00:40:07.820 | And why is that?
00:40:09.060 | How could that be?
00:40:11.460 | What's going on here?
00:40:13.020 | Some of you probably know.
00:40:15.060 | What's going on is contributions.
00:40:17.300 | And by the way, I've taken these drawdown numbers just
00:40:20.860 | before the next contribution, so they're worst case.
00:40:24.180 | But if you ask a young investor when the market's down
00:40:27.740 | how bad their investments have done, almost none of them
00:40:30.380 | have run an IRR calculation and can tell you.
00:40:33.420 | They just look at their balance and say, well,
00:40:35.340 | it's bigger than it was last year.
00:40:36.740 | It doesn't look too bad to me.
00:40:38.660 | And people who advise young investors actually see that.
00:40:41.900 | And if you don't believe me, we can actually
00:40:43.700 | look at a back test here.
00:40:45.140 | I chose a volatile asset class.
00:40:46.820 | This is small cap value.
00:40:48.020 | We started in 1970.
00:40:50.060 | And this grayed out deep drop right here
00:40:53.460 | is what a lump sum investor would have experienced.
00:40:56.220 | And these shallow dips up here are
00:40:59.420 | what the dollar cost averaging or the annual contribution
00:41:03.700 | investor experienced, much, much shallower drawdowns.
00:41:06.980 | And it's because they've got these regular contributions.
00:41:10.780 | So with that in mind, knowing that there's
00:41:13.780 | a little more room for risk, we'll
00:41:15.940 | analyze the target date fund.
00:41:18.940 | But let's also look at some simple ways
00:41:21.380 | we could spice it up.
00:41:23.340 | And these are three strategies that come out
00:41:26.740 | of our two funds for life book.
00:41:28.460 | One is easy, and this is simply a 90/10 allocation,
00:41:31.980 | 90% to the target date fund, 10% to small cap value.
00:41:36.180 | And it's not rebalanced during the early years.
00:41:40.540 | And then it is nudge withdrawals in the retirement years.
00:41:47.620 | Now, what do I mean by nudge withdrawals?
00:41:49.300 | I just mean you take your whole withdrawal out
00:41:51.340 | of whichever fund is too big.
00:41:53.820 | So you've got a 90/10 allocation.
00:41:55.620 | If the target date fund is 11%, you
00:41:57.660 | take your 4% withdrawal from that.
00:42:00.300 | If the target date fund is at 91%,
00:42:04.540 | you take the withdrawal from that.
00:42:07.420 | So it's simple, and in my back testing, it works pretty well.
00:42:12.580 | And it avoids having to make a lot of emotional decisions
00:42:15.500 | about rebalancing.
00:42:17.180 | The second strategy we'll look at
00:42:18.860 | is a moderate one that starts at about a 60% allocation
00:42:23.140 | to US small cap value and declines all the way down
00:42:27.700 | to the full target date fund, 100% in the target date
00:42:32.300 | fund in retirement.
00:42:33.980 | And that's the moderate two fund for life.
00:42:35.820 | And then the last one, let's just be crazy.
00:42:38.460 | And we'll go aggressive.
00:42:39.460 | We'll go hyper-aggressive.
00:42:40.540 | We'll be 100% target date fund in the early years,
00:42:43.340 | because remember, there wasn't enough risk there.
00:42:45.860 | So let's see if this just pushes us over the edge.
00:42:49.020 | And we'll ramp that down to 20% in retirement,
00:42:51.860 | because it might improve the safe withdrawal
00:42:54.180 | rates in retirement.
00:42:55.540 | And let's see how those did.
00:42:58.140 | So if we take a look at it, what we see
00:43:02.300 | is that the target date fund is--
00:43:05.020 | these are the 1928 numbers.
00:43:07.260 | It's going to potentially make you tolerate a 65% drawdown,
00:43:11.740 | but it's going to give you a very solid 8.5%
00:43:14.780 | rate of return for that.
00:43:16.820 | And it's going to have the diversification we expect,
00:43:20.780 | just credit, term, and market.
00:43:23.900 | This easy strategy gives you about an extra 1% in return,
00:43:28.740 | slight increase in the drawdown, a little bit of a bump
00:43:32.460 | in the drawdown towards retirement.
00:43:34.180 | That's not ideal, but a much more diversified portfolio
00:43:38.940 | down here in terms of the attributes
00:43:42.260 | the portfolio is firing on.
00:43:44.060 | And then the moderate one, the moderate two-fund-for-life,
00:43:46.900 | is about the same return, but it tames the risk out here
00:43:49.980 | by retirement.
00:43:50.900 | So this is lower, and it brings some of that risk
00:43:54.220 | into the early years.
00:43:55.940 | And interestingly, it's not as diversified.
00:43:59.060 | Why is it not as diversified?
00:44:00.540 | I mean, we've got that 100% allocation to small in value
00:44:03.540 | in the early years.
00:44:04.860 | Well, the reason it's not as well diversified
00:44:07.300 | is there aren't as many dollars in those early years.
00:44:10.180 | So even though it sounds extreme to pull the asset allocation up
00:44:15.500 | in the early years, you're not taking a risk
00:44:18.060 | with a huge amount of dollars.
00:44:19.300 | So it doesn't tilt it that much.
00:44:20.660 | And then the most aggressive one over here,
00:44:22.460 | obviously the highest return, comes with the highest risk,
00:44:26.820 | but the highest amount of diversification.
00:44:29.300 | And I think that this is intriguing,
00:44:33.140 | but if I was a young person, what I'd really want to know
00:44:35.660 | is, how did they do at multiplying my buying power?
00:44:40.420 | What's my real dollar benefit from doing this?
00:44:43.900 | And to do that, we need to calculate
00:44:45.580 | what I call a real dollar multiplier.
00:44:47.980 | And the way we'll do that is we will remove inflation
00:44:51.860 | to get the real future balances and the real contributions.
00:44:56.580 | And we will divide the real balance
00:44:59.500 | that we have at 40 years--
00:45:01.140 | that's the inflation-adjusted real purchasing power--
00:45:05.460 | by the total real contributions that we've made.
00:45:08.140 | And when we do that, we get a really interesting set
00:45:12.020 | of numbers down here at the bottom.
00:45:13.900 | Every single one of these strategies
00:45:16.140 | did better than double your purchasing power
00:45:19.540 | across a 40-year period of accumulation
00:45:22.340 | across all of the time frames that we looked at.
00:45:25.660 | That was the worst.
00:45:26.780 | They all did better than double.
00:45:29.780 | The place where they really differ is in upside.
00:45:32.500 | The target date fund gives you about an upside,
00:45:36.300 | the best-case scenario, of multiplying your purchasing
00:45:39.140 | power by about 5 and 1/2.
00:45:41.500 | The easy two funds for life is a little more than 7.
00:45:45.900 | The moderate two funds for life was almost 8.
00:45:50.340 | And the aggressive strategy was about 14.
00:45:53.900 | So the averages are between the two.
00:45:56.700 | And the medians, or the expected values, are between the two.
00:45:59.820 | So each of these strategies, as it takes more risk,
00:46:02.940 | is likely leading to you having more purchasing power later
00:46:06.260 | in life, which I think is powerful.
00:46:10.340 | So that covered accumulation.
00:46:12.020 | But what about retirement?
00:46:15.140 | To do retirement, we're going to use a different multiplier.
00:46:17.580 | We're going to look at the nest egg multiplier, which
00:46:19.780 | is the real withdrawals plus the real end balance divided
00:46:22.860 | by the initial nest egg.
00:46:24.900 | So that's all the money you get to spend in retirement
00:46:27.100 | plus pass on to errors divided by the initial nest egg.
00:46:30.820 | And what we see here is that, again, there's
00:46:34.460 | this growing increase between--
00:46:37.860 | by the way, I've combined the target date fund
00:46:39.900 | and moderate in this column because they're
00:46:42.220 | the same thing.
00:46:43.100 | They're all 100% target date fund in retirement.
00:46:45.940 | So that's about a 7.2 CAGR.
00:46:48.620 | The easy one is about a 7.7 CAGR.
00:46:51.700 | The aggressive is about 8.7.
00:46:55.020 | And because the aggressive is tilting us more towards the US,
00:46:58.780 | I added another aggressive over here
00:47:00.860 | that includes a mix of US and international small cap value.
00:47:05.660 | And it performed a little bit more poorly,
00:47:07.660 | but is better balanced in terms of its geography.
00:47:11.260 | The scary part, though, most of you who are watching
00:47:13.780 | have probably already picked up on it,
00:47:15.380 | is that these ran out of money in retirement.
00:47:17.740 | Now, this is a 40-year retirement,
00:47:19.540 | so it's a long time of 4% withdrawals.
00:47:22.500 | They all, at some point from 1928 to 2021,
00:47:27.820 | on one of those scenarios, ran out of money.
00:47:30.620 | But what's more meaningful is probably their survival rates.
00:47:33.980 | And that's right here.
00:47:35.740 | And they all did pretty well.
00:47:37.340 | So the target date fund had a 99% survival rate for 30 years
00:47:42.060 | and an 88% survival rate for 40 years.
00:47:46.060 | As we go across the chart, they get better.
00:47:48.820 | The easy-to fund for life was 97%, roughly,
00:47:53.460 | in terms of the 40-year safe withdrawal rate --
00:47:56.500 | or, I mean, survival rate.
00:47:57.700 | And the aggressives both had practically 100%.
00:48:03.260 | And down at the bottom,
00:48:05.500 | if we look at their safe withdrawal rates,
00:48:08.260 | the best safe withdrawal rates --
00:48:10.340 | actually, the aggressive strategy.
00:48:12.620 | So, again, as a retiree,
00:48:14.900 | I would encourage you to hold some small-cap value
00:48:17.620 | because it's going to boost the resilience of your portfolio.
00:48:21.500 | And the multipliers are down here at the bottom.
00:48:24.700 | The worst, 1.1, is for the target date fund,
00:48:28.220 | but they're all about the same -- 1.1, 1.2.
00:48:31.100 | And the upside benefit just comes with more tilt
00:48:33.340 | towards the more volatile assets of small-in-value.
00:48:37.660 | So the final topic, what do we give up by being simple?
00:48:42.580 | Well, I've analyzed a very complicated
00:48:46.660 | Merriman target-date portfolio using 13 asset classes.
00:48:51.220 | That's over on the right.
00:48:52.340 | And a two-fund-for-life aggressive strategy.
00:48:55.260 | And the answer is not much.
00:48:57.740 | The two-fund-for-life aggressive
00:48:59.300 | actually had the higher return, very slight.
00:49:03.020 | I'd say that for all intents and purposes, they're the same.
00:49:06.900 | But what this says is with two funds,
00:49:09.140 | you could do almost everything you can do with 13,
00:49:12.140 | and it's much, much easier to manage.
00:49:15.140 | There are things that we give up, though, some real things.
00:49:18.100 | And the most important one is probably tax efficiency.
00:49:21.180 | When you bundle your equities and your bonds
00:49:23.460 | together in a single fund, you can't --
00:49:25.940 | if they're all in a tax-deferred fund,
00:49:28.540 | a Roth IRA or a 401(k), you're fine.
00:49:32.980 | But if they're in a taxable account,
00:49:35.420 | you'd really like to separate out the bonds
00:49:37.380 | and put them in the tax-deferred account.
00:49:39.100 | So that's a cost to simplicity.
00:49:41.460 | You can't do the account location as precisely.
00:49:45.580 | You also can't control individual attributes
00:49:48.060 | of the portfolio as precisely.
00:49:50.500 | You don't have independent control
00:49:52.460 | over the U.S. international small/large value growth splits.
00:49:58.820 | You lose some regret avoidance.
00:50:01.180 | You know, if large-cap blend is the hot thing last year,
00:50:05.940 | if it had the best return, you don't hold that fund,
00:50:10.100 | and you might regret that.
00:50:11.380 | So that's an issue.
00:50:12.540 | And then personal preference.
00:50:13.820 | Some people just like the complexity.
00:50:17.700 | So in summary, simple, balanced portfolios
00:50:20.500 | can broadly diversify across companies,
00:50:22.700 | countries, factors, age,
00:50:25.180 | and they can improve the likely return per drawdown risk
00:50:29.500 | in accumulation and improve your safe withdrawal rates
00:50:32.100 | and survival rates and resiliency
00:50:34.020 | and end balances in retirement.
00:50:36.220 | But they do give these few things up --
00:50:38.380 | customization, tax efficiency,
00:50:40.980 | the chance to always own what's hot,
00:50:43.180 | and the chance to be with the herd.
00:50:45.900 | So I'd encourage you to look for more on our website,
00:50:49.340 | to sign up for the newsletter
00:50:50.900 | and get Paul and Rich's excellent book,
00:50:53.180 | "We're Talking Millions."
00:50:54.780 | And if you want the deep dive into Two Funds for Life,
00:50:58.500 | buy my book, "All the Profits Go to the Foundation."
00:51:01.540 | And just a quick disclaimer,
00:51:04.660 | everything in this presentation is informational.
00:51:06.860 | I can't be your advisor,
00:51:08.180 | and I'm sure it has some mistakes, so no...
00:51:10.660 | ♪♪
00:51:20.660 | ♪♪