One Portfolio for life?

Many do-it-yourself investors want solutions they can implement once, then leave alone. Can individual investors adopt a strategy that's so good it will meet their needs from age 21 to 91? In this article, FundAdvice.com Publisher Paul Merriman and Managing Editor Richard Buck tell why they think the answer is yes.

Much of the work we do is focused on helping individual investors find just the right combinations of assets and forms of investment ownership (IRAs, taxable accounts and the like) to meet their individual needs. Since everybody’s financial situation is unique and usually evolving, we are not big fans of one-size-fits-all solutions.

We spend lots of time helping each person determine his or her risk tolerance. This is one of the most valuable things professional advisors do for their clients.

But we know that in real life many investors do not have professional help. Realistically, many do-it-yourself investors simply don’t take the time to adjust their investments to their changing needs and tolerance for risk. We know that many people want solutions they can set up once and then forget about.

We can't ever know in advance what the very best strategy will be. But here's an interesting question: Is there a single portfolio that will do a good job of meeting the needs of investors for 70 years, from age 21 to 91? We think the answer is yes.

The conventional wisdom holds that young people in their 20s and 30s should take bigger risks, typically investing exclusively in equities so they can maximize their opportunities for growth. That same wisdom dictates that older folks, especially those who are retired, should be much more cautious, having most of their money in cash, bonds and bond funds.

An old rule of thumb dictated that the percentage of equities in a portfolio should be determined by subtracting the investor’s age from 100. Thus a 50-year-old would have a 50-50 split between equity funds and fixed-income funds while a 75-year-old would have only 25 percent in equity funds.

THE PENSION FUND EXAMPLE

While that formula is simple and easy to understand, it requires an asset allocation change every year. We think the example of large pension funds is a better one for individuals to follow. Pension funds are by nature conservative, since they exist for only one purpose: to make sure that retirement money will be available when it’s needed, for as long as it’s needed.

The typical pension fund portfolio is invested 60 percent in equities and 40 percent in fixed-income instruments. Over many years, this has turned out to be a good compromise between the need for growth (from equities) and the need to reduce risks. Historically, the 60 percent in equities has given pension funds high enough returns to stay ahead of inflation while the 40 percent in fixed-income has protected the portfolio against devastating downturns.

If this 60/40 split is good enough for a perpetual pension fund, we believe it should also be good enough for most individuals. This is the basic allocation we’re suggesting for a lifetime portfolio.

If young people were truly buy-and-hold investors, we think it’s likely that they would be quite successful over the long term with all-equity portfolios. However, buying and holding is harder than it sounds.

The fact is that many investors of all ages over-expose themselves to equities. Inevitable market setbacks then lead to panic selling, usually after securities prices have fallen significantly. People typically re-enter the market quite cautiously, not buying until prices have risen significantly. This cycle makes it nearly impossible to do what investors say they want to do most: buy low and sell high.

To stay the course, investors need to avoid panic. Often, this requires a feeling of comfort, which of course is typically a product of owning fixed-income funds that reduce volatility and losses but which at the same time reduce returns.

Any portfolio worth holding “for life” needs to provide enough comfort to avoid emotional buying and selling while still providing a solid return. With proper diversification, this is possible. Let’s look at some numbers.

THE NUMBERS

Using the database of Dimensional Fund Advisors, our research department computed some returns for the years 1955 through 2004, a 50-year period that included many different types of markets, including boom years, bust years and “sideways” years.

We began by comparing three potential portfolios. One was made up exclusively of the S&P 500 Index, an all-equity allocation that represents what investors might expect without any of the stability (and comfort) of fixed-income funds. The second was invested 60 percent in the S&P 500 Index and 40 percent in five-year Treasury notes. This is very easy for any investor to replicate.

The all-equity S&P 500 Index portfolio had an annualized return of 10.9 percent over that 50-year period. The 60/40 version’s annualized return was 9.6 percent. This was no surprise, because adding fixed-income funds to an equity portfolio almost always reduces return. In this case, the 60/40 mix achieved 88 percent of the return of the all-equity portfolio.

There’s only one reason an investor would adopt a portfolio that is almost certain to have a lower return: to reduce risk. This raises the question: Did the 60/40 portfolio do that? To quantify the answer during this 50-year period, we calculated each portfolio’s largest drawdown, the maximum temporary (but very real at the time it happened) percentage loss.

In the portfolio made up exclusively of the S&P 500 Index, the biggest drawdown was a loss of 45 percent. In the 60/40 portfolio, it was a loss of 26 percent.

Statistically, you could say the 60/40 portfolio reduced return by 12 percent while reducing risk by 42 percent. Or you could say the 60/40 portfolio provided 88 percent of the return with only 58 percent of the risk.

Either way you look at it, that is a very big improvement. But it’s probably not enough to attract many investors away from the lure of the higher return in the all-equity portfolio.

This led us to test a third potential portfolio. Its fixed-income portion was identical, made up of T-notes. The 60 percent equity allocation was divided equally in four ways: large-cap stocks, large-cap value stocks, small-cap stocks and small-cap value stocks.

Except for the use of international equity funds, which we strongly recommend and will discuss below, this four-way allocation mirrors the diversification we have been recommending for many years.

Over the 50 years in our study, this diversified 60/40 portfolio produced a return of 11.4 percent, with a maximum drawdown of 25 percent. Compared with the all-equity portfolio, this diversified mix raised the return by an extra 0.5 percentage point while it reduced the risk by 44 percent.

An increase from 10.9 percent to 11.4 percent might seem small. But our interest here is not in short-term results. We’re looking at a portfolio that’s suitable for a lifetime. Over an investor’s lifetime, a 50-year span is hardly out of the question. In 50 years, $100 invested at 10.9 percent would grow to $17,643. The same $100 invested at 11.4 percent would grow to $22,093.

That’s a difference of $4,450, an increase of 25 percent. In dollar terms, that difference alone is equal to more than 44 times the entire original investment of $100.

Of course we believe it’s likely that investors will achieve higher long-term returns with an all-equity portfolio diversified along the lines we just outlined. But we also believe that most investors can meet their lifetime goals with returns comparable to those of the Standard & Poor's 500 Index. And we’ve just shown how they can do that with much less risk than investing exclusively in that popular index.

KEEPING YOUR BALANCE

The diversified 60/40 portfolio we have described requires very little maintenance, but there is some. Though annual rebalancing is not absolutely necessary, if it’s neglected, the portfolio’s risk can start creeping up. To maintain the proper amount of risk, you should keep the portfolio within reasonable distance of its 60/40 target allocation.

When the stock market is hot, as it was in the 1990s, the equity part of a balanced portfolio can quickly creep up. We studied a hypothetical portfolio that began with 60 percent in U.S. equities and 40 percent in bonds at the start of 1990 to see what happened to that allocation without rebalancing. By the end of 1999, 78 percent of the portfolio was in equities and only 22 percent in bonds.

Unfortunately, that was just in time for the bear market of 2000 through 2002 to come along and teach unwary investors about the dangers of being over-exposed to equities. The portfolio that had never been rebalanced lost 22.2 percent of its value from the end of 1999 through 2002. But if that portfolio had been rebalanced every year, the loss was only 12.6 percent.

Maintaining your balance is quite easy. If you can keep your asset balances close to your targets by allocating new contributions, that’s recommended. Otherwise, rebalance your investments once a year by selling funds that have been recent winners and buying more of those that have been recent laggards.

Many people balk at the counter-intuitive nature of rebalancing, thinking they are being asked to “punish” their winners and “reward” their losers. A more productive attitude is to think of rebalancing as a mechanical way to require investors to buy low and sell high. After all, that is the most basic formula for success that’s ever been invented.

For the sake of simplicity, international equity funds were excluded from each of the three lifetime portfolios outlined above. But a lifetime portfolio would undoubtedly be stronger if it included international funds. We have believed – and we have said – for many years that U.S. investors who balance their U.S. equities with international ones can gain an enormous long-term benefit.

GOING GLOBAL

Whenever we can, we persuade our clients to split their equity holdings 50/50 between U.S. and international funds. We believe younger investors need international funds for growth while older investors, especially retirees taking money out of a portfolio, need international funds for their ability to reduce volatility by counteracting some of the ups and downs of the U.S. stock market.

To illustrate the benefits of international investing, we made a study of actual year-by-year returns from 1970 through 2004 in a hypothetical retirement portfolio that started with $1 million from which a retiree withdrew $60,000 the first year and then increased the annual withdrawal by 3.5 percent per year.

We tracked three variations of such a portfolio.

· Invested exclusively in the Standard & Poor's 500 Index, the portfolio was worth only $182,504 at the end of 2004. Since that was less than the required distribution in 2005, the portfolio was effectively broke.

· If the equities were equally divided four ways among U.S. large-cap stocks, large-cap value stocks, small-cap stocks and small-cap value stocks, at the end of 2004 the portfolio was worth $8.2 million and in no danger of running out of money any time soon.

· We then created a fully diversified global equity portfolio by putting half of that second portfolio into international stocks, with the international allocation divided five equal ways into large-cap stocks, large-cap value stocks, small-cap stocks, small-cap value stocks and stocks in emerging markets. This time, the 2004 year-end portfolio was worth $40.8 million.

That last figure tells us that – at least in the past 35 years – a retiree following a rigorous withdrawal plan would have benefited substantially from adopting global diversification rather than sticking to an all-U.S. portfolio.

These were all-equity portfolios, representing more risk than we think is appropriate for most retirees. Therefore, in our study we also measured the effect of putting 40 percent of the globally diversified portfolio in short-term bonds. We found the year-end 2004 value was $14.4 million.

That demonstrated what we talked about earlier, that global diversification can make it possible to achieve equity-style returns while using bond funds to greatly reduce the risk of the portfolio.

Many investors are skeptical about such a high percentage of international funds. We would remind them that about half the world’s equity market is outside the United States and there is no fundamental reason that U.S. stocks should outperform (or underperform) stocks from other countries on a long-term basis. In addition, international equities provide a hedge against the value of the U.S. dollar. If, as many experts believe, the dollar continues to slowly decline against other currencies, that decline will most likely lead to outperformance by international equities.

Over any short period of time, international stocks might or might not add value to a portfolio. But over the long haul – precisely the time frame we’re talking about in this article – they have done so.

For a longer discussion of the value of international stocks, including some dramatic graphs, see our article “Why invest so much in international funds?”

LIFESTYLE FUNDS

Many mutual fund companies have tried to create a single portfolio “for life” through the use of lifestyle or “target” funds that are based on investors’ ages. We’d love to be able to recommend even one such fund. But many lifestyle funds cripple their shareholders by being overly cautious, while others can be too aggressive for most people’s risk tolerance. Also, lifestyle funds typically rely overwhelmingly on U.S. large-cap growth stocks, an equity class that historically underperforms over long periods of time.

An example of a lifestyle fund is Fidelity’s Freedom 2020 Fund (FFFDX), aimed at people who expect to retire in that year. This fund currently invests about 70 percent of its $11 billion portfolio in stocks and the rest in cash and bonds.

While funds like these give investors lots of convenience, we don’t think they dish up what investors really need. At Morningstar.com, Freedom 2020’s huge equity portfolio lands squarely in the large-growth style box.

One thing investors need is value; we recommend that value stocks make up half of the equity part of a portfolio. Freedom 2020’s equity holdings are only 9.3 percent value.

Investors also need small-cap stocks; we recommend they make up half the equity part of a portfolio. But small-company stocks make up only 3 percent of Freedom 2020’s equity holdings.

Investors also need international stocks; we recommend they make up half the equity part of a portfolio. Freedom 2020’s international stocks are only 6.8 percent of its portfolio.

In addition, funds like this are based on the assumption that all investors should start out being aggressive and then gradually become more conservative. The Freedom 2040 Fund, presumably for investors with 35 years to go before retirement, has 85 percent of its assets in stocks. Freedom 2005, aimed at this year’s retirees, holds 65 percent of its assets in cash and bonds along with 35 percent in stocks.

We believe most retirees can tolerate the risks – and they can certainly use the long-term growth – of a portfolio that’s 60 percent in stocks.

We think a 60/40 portfolio will serve well for most investors, whether they are accumulating assets or distributing them in retirement. If you’re relatively healthy at age 65, you still have potentially 30 or more years in which to rely on your investments.

In a healthy couple at age 65, there’s a 50-percent chance that one member will live to be 92 and a 25 percent chance that one member will live to age 97. That’s much too heavy a burden for a portfolio that’s made up mostly or exclusively of fixed-income investments. To keep up with inflation, a portfolio needs the growth that comes from owning a diversified mix of equities.

You can learn more about why we say that in an article called “Retirement: When Your Portfolio Starts Paying You.”

PUTTING IT TOGETHER

There are many ways a portfolio of this nature can be put together. The most basic allocation is 60 percent to equity funds and 40 percent to fixed-income funds.

When choosing funds, we believe you’ll get the best results from no-load index funds. When index funds are not available for your particular needs, look for no-load funds with low expenses, low portfolio turnover and portfolios that contain many stocks, not ones concentrated in a relatively few stocks.

Fortunately, you don’t have to do all that homework yourself. We have done it for you. Just look up our suggested “balanced” portfolios for investors at Schwab, Fidelity, T. Rowe Price and Vanguard, each of which has percentage recommendations that will produce a 60/40 portfolio.

However you invest it, your portfolio will eventually represent the work you’ve done over a lifetime. A 60/40 allocation will let you put your savings to work for you for a lifetime.

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