The use of static portfolios or Target Date funds is prolific throughout the industry. Many 401k plans are offering target date funds that decrease stock exposure as one ages or gets closer to the target date.
However, as Inker and Tarlie found out (see my previous article The 401K Investment Challenge) a Dynamic approach, one that increases or decreases stock exposure as valuations increase or decrease, improves the probability of success. Inker and Tarlie found that the Dynamic approach has a 5% chance of failure while the static approach and target date fund approach have significantly higher chances of 20% of not getting through retirement.
The research looked at the probabilities from a historical approach. The Dynamic approach prevailed. Specifically, when Inker and Tarlie looked at a similar time period to today, when interest rates are low and valuations are high, like they were in 1965, they found that static portfolios did poorly for investors in the accumulation phase or the retirement phase.
Beginning in 1965, when stock valuations were high and interest rates were low, stocks and bonds suffered poor returns. A static portfolio faired unfavorably versus a Dynamic approach during this time. This was specifically because a static approach would ignore high stock valuations.
The chart below from Inker and Tarlie compares what the stock exposure would look like for an investor beginning in 1965.
The relationship between stocks and bonds in 1965 is not too different than what we have today. The expected return to stocks is actually lower than bonds due to high valuations. Therefore, having stock exposure is not a likely way to help much in the next few years.
More importantly, the static strategy leaves the investor out of money by 1992. The cost to the investor is not only quantifiable, but also devastating. Proving that not accounting for the changing valuations of the stock and bond markets over time is a vital flaw to the creation of a portfolio.
And yet, due to the large run up in stocks in 2013, more individual 401k investors are putting money into stocks. My next article will discuss short-termism and constant expected return.
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