Investment Portfolios Should Look Different in Retirement
Your investment portfolio is likely one of your largest and most important assets being relied upon to fund your retirement if you are like most. As such, it is imperative the investment portfolio be structured and managed well. No longer can you take the cavalier approach you once could when you were younger and saving for a time way off in the distant future. There is less time to rebound from mistakes now.
How should an investment portfolio look differently in retirement? For starters, volatility becomes much more of a factor as sequence-of-returns-risk is highest early in retirement when the portfolio is largest. Ensuring your portfolio is well constructed and diversified is key to minimizing volatility. Second, because you cannot afford to take concentrated risks to try and hit home runs anymore, keeping as much return as you can becomes more critical. This means paying attention to fees that can eat away at your returns.
Adopt a Passive Investment Philosophy
The best way to achieve both of these goals is to adopt a passive (or index-based) investment philosophy. A passive investment philosophy embodies a long-term, strategic investment strategy that follows the Modern Portfolio Theory tenets. The belief that diversification offers the best protection against risk and that investment markets are efficient over time. A passive philosophy proponent does not believe it makes economic sense to attempt timing or outperforming investment markets. Instead, they believe in seeking broad-based exposure to desired asset classes by investing in low-cost index funds. After building a portfolio, that portfolio is rebalanced as necessary, employing a disciplined rebalancing strategy.
Some dismiss passive investing because they mistakenly see it as a "do nothing" approach to investing. This belief could not be further from reality. There is no such thing as being completely passive when it comes to investing. Forecasts of expected returns and risk factors must be created, asset classes must be evaluated for inclusion, efficient portfolios must be constructed, and index funds must be evaluated and selected. Additionally, a rebalancing strategy must be determined, the portfolio monitored, and trades executed upon when required by the selected rebalancing strategy.
The "passive" part of passive investing comes into play when it comes to reacting to the market's short-term ups and downs. A passive philosophy follower believes investment markets are efficient over the longer-term and that it does not make economic sense to incur the extra costs of active management in an attempt to benefit from short-term market inefficiencies or market timing. Markets can behave wildly and unpredictably in the short-term, but investment returns tend to behave much more predictably as the risk-return relationship plays out. All investments have a specific risk and return profile that they eventually follow. This concept is known as reversion to the mean. It is very difficult to time this reversion, given how difficult it is to predict what could happen or how markets react to an event even if it were predicted and the timing was right.
The S&P Dow Jones Indices publishes a robust, widely-referenced research piece known as The SPIVA Scorecard that compares actively managed funds against their appropriate benchmarks on a semiannual basis. SPIVA® research has shown over 15 years of published data surveying more than 10,000 actively managed funds globally that relatively few active managers can outperform passive managers over any given time period, let alone deliver above-average returns consistently over multiple time periods. Referencing SPIVA's five-year data for the period ending June 30, 2020, you can see that almost 80% of funds failed to meet their benchmark return.
Benefits of Passing Investing
There is a reason professional investors from John Bogle to Warren Buffet praise the benefits of passive investing. Passive investing yields many tangible and intangible benefits to individual investors. First, investors can often save more than 1.00% alone based on the average expense ratios of the funds being held in a portfolio. Based on the average expense ratios listed in the Investment Company Institute's® 2020 Factbook, a 50% stock and 50% bond portfolio would carry an average expense ratio of 1.18%. Using only low-cost index funds, you can build an efficient, diversified portfolio for a weighted average expense ratio of less than 0.10%. Second, passive investing strategies often require less trading activity leading to lower transaction costs and higher tax efficiency. Lastly, passive strategies are generally easier to understand. This relative simplicity and transparency make it much easier to follow and evaluate the investment strategy saving investors much stress and anxiety.
Investment Portfolio Construction
While it's true you can't control the market, you can at least build an efficient portfolio that correctly exposes you to the right asset classes in the right proportions and that offers you broad, diversified market coverage without overlap.
Determine Asset Classes
We start by examining the investment universe for investable asset classes. For an asset class to be worth including in a portfolio, it should:
1). Be fundamentally different – For an asset class to be fundamentally different, it must be driven by unique risk that can be tested through a rolling correlation analysis. The idea here is that it does no good to add an asset class to a portfolio that behaves like another asset class already in the portfolio. We want asset classes that respond to different risks so that their movement is not correlated. This is the essence and benefit of diversification. If we have two assets, both with positive expected returns, but they both take a different path to those returns, it smooths the overall path of return the portfolio as a whole takes. In other words, it reduces the portfolio's overall return volatility.
2). Earn an expected real return – A real return is the portion of return that exceeds the rate of inflation. If an asset class cannot contribute to the real return over time, it makes no sense to add that asset class. An example of an asset class that fails this part of the test is commodities. Commodities are not income-producing assets and therefore can not be valued as such and grow when income grows. The price of commodities is determined by supply and demand factors. The price of a commodity will move up and down to maintain equilibrium between supply and demand. But over time, the equilibrium price will only move up by the rate of inflation.
3). Be investable in a low-cost, diversified way – Being able to invest in an asset class in a low-cost, diversified way means that a fund or product must exist that you can buy to give you broad-based exposure to the asset class at a low cost. Many asset classes fail this test. Most alternative assets such as hedge funds and private equity fail the low-cost part of the test. Other asset classes such as collectibles and art fail this test because there is no way to invest in those assets in a diversified way.
As of this writing, the following nine asset classes pass these three tests, and we believe should be considered in an investment portfolio:
- U.S. Total Stock Market
- U.S. Real Estate Investment Trusts (REITs)
- Developed Markets Europe
- Developed Markets Asia-Pacific
- Emerging Markets
- U.S. Total Bond Market (investment grade)
- Total International Bond Market (investment grade)
- U.S. Treasury Inflation-Protected Securities
- U.S. High Yield Corporate Bonds (non-investment grade)
Now we must decide how much to allocate to each asset class. The modern portfolio-theory approach is to invest proportionally according to market capitalization. Otherwise, you are missing out on diversification and return potential as well as making a bet.
Examining the World's Market Capitalizations
As an example, courtesy of Dimensional Fund Advisors, the following is the world's stock market capitalization by country as of December 31, 2018:
This data suggests that an investor should maintain a 54% U.S. and 46% non-U.S. split in their stock allocation. While this represents a reliable foundational approach, there are several reasons for U.S.- based investors to maintain a slightly greater tilt to the U.S.
- Despite increasing efficiencies, global markets are not yet fully and seamlessly integrated, and transaction and investment costs generally remain proportionally higher in foreign markets than in the United States. Foreign markets also tend to have wider bid-ask spreads and higher management fees and friction costs.
- Some foreign markets do not have stable political and legal systems that are conducive to investment. Countries differ in their political risk exposures, regulatory frameworks, and pro-investor laws and protections.
- Investors have local and global biases (whether justified or not). Investors tend to prefer what is familiar to them, producing a behavioral bias toward local markets.
Maintaining some home country bias makes sense. We believe in a 60% U.S. and 40% international split on the portfolio's stock side.
After following this approach with the remaining asset classes to determine your desired asset allocations, it is time to research the available fund universe to find the fund that best represents the asset class exposure you desire in your portfolio.
Determining the Best Funds
The best fund will be the fund that gives you the broadest possible exposure to the desired asset class that is also low-cost. We already now know that index funds are going to meet these criteria best.
An index fund is designed to capture the return of the "market" as defined by a benchmark index. For instance, an index fund designed to track the S&P 500 index will try to replicate that index's return. To find an index fund that will give us the broadest possible exposure to an asset class, we need to find an index with the broadest possible measure and then look at the available funds that track that index. For example, numerous benchmark indices are designed to track the U.S. stock market. To name a few, there is the Dow Jones Industrial Average, the Standard and Poor's (S&P) 500, and S&P Total U.S. Market Index. While all are designed to track the U.S. stock market, they are created very differently and represent very different exposures within the Total U.S. Stock Market. The Dow Jones Industrial Average only includes stocks of the largest 30 companies; the S&P 500 only includes the stock of the largest 500 companies; and the S&P Total U.S. Market Index includes approximately every stock available. So clearly, the S&P Total U.S. Market Index would be the best available measure of the U.S. Total Stock Market asset class.
While this exercise may seem tedious, it is vital to your investment portfolio's overall return potential. In any given year, the vast majority of the market's return is driven by a relatively small proportion of stocks, and we have no way of knowing in advance which stocks will be those leaders. Following is some research from Dimensional Fund Advisors:
An investor who simply held every stock available in the world across 44 countries from 1994 to 2018 would have received a 7.2% annualized return. Just removing the top 10% of performers each year would have taken that return down to 2.9%. If you were to remove the top 25% of performers each year, you would have actually lost -5.1% per year. You cannot afford not to hold the potential winners, and you have no way of knowing in advance who they will be. This is why we want the broadest exposure possible while avoiding overlap. The broader the exposure, the better your chance at capturing the market leaders in any given year.
Following this process for each asset class exposure you want to include in your investment portfolio can lead to some incredibly well-built and efficient portfolios.
This is a Portfolio Built for Retirement
Following the processes laid out in this insight, we at Thrive Retirement Specialists tailor portfolios for clients using nine index funds, each representing one of the nine asset classes identified earlier. We help clients gain exposure to over 36,000 holdings across all investable 44 countries through these nine funds, all for a weighted average expense ratio of less than 0.10%. Now, this is a portfolio built for retirement! The best part is we do so while charging a flat fee rather than the norm of charging a percentage of asset under management (%AUM) fee, but this is another story.
We stand by ready to help if you need assistance reassessing your investment portfolio. If you have any questions, please feel free to reach out.
ABOUT THRIVE RETIREMENT SPECIALISTS
Thrive Retirement Specialists is a retirement planning specialist dedicated to delivering a more thoughtful and strategic approach to retirement planning for those nearing or in retirement. We are a fee-only Registered Investment Advisor (RIA) offering a single, flat-fee service entitled ThriveRetireTM that goes far beyond what has traditionally been known as retirement planning. ThriveRetire™ is an engaging ongoing 8-step retirement planning process and investment management service that seeks to identify all risks, assets, tools, and tactics to develop an optimal retirement plan designed to support your ideal retirement lifestyle and goals to the fullest extent possible. With every interaction, we seek to inform and serve, so our clients can safely trust their ThriveRetire™ plan and process, leaving each client with the confidence and peace of mind to live a vibrant and full life through retirement.
ABOUT ANTHONY WATSON, CFA, CFP®
Prior to founding Thrive Retirement Specialists, Tony spent eight years serving as the Chief Investment Officer of a firm where he provided advice and investment management services to over 600 individuals representing at the time over $1.5 billion of investments. Before this, Tony served as Vice President at J.P. Morgan Private Bank, where he advised high- and ultra-high net worth individuals on all matters of wealth, including investments, portfolio construction, portfolio management, and retirement planning.
Tony lives in Dearborn, Michigan, with his wife Dawn and daughters Emma and Anna.
- BBA in Finance, Walsh College
- MBA, University of Michigan, Ross School of Business
- Chartered Financial Analyst (CFA)
- Certified Financial Planner (CFP®)