We can’t dismiss our culpability entirely. The current national savings rate posted by the Federal Reserve hovers around 5%, not nearly enough to fund our golden years no matter what we invest in.
It is true that fees nonetheless take a major chunk out of portfolios. Compound interest, the mechanism at work for all investment returns, has the glorious effect of growing assets exponentially over time. The downside to this phenomenon is that fees also have an exponential effect, eating a bigger and bigger chunk of possible returns as the years go by. For long-term investments like retirement savings, even moderate fees have a huge impact.
One answer to this problem is to choose a few simple low-fee investments like passive funds and ETFs, bypassing higher fee mutual funds and fee-charging advisors. When you opt for passive options on your own, then you are faced with a new problem: asset allocation. Asset allocation is the process of divvying up dollars into different asset classes, like large or small cap stocks, bonds, commodities and other alternatives.
Here are 10 reasons why retirement riches spring from allocation, and why you should rethink just how much you can do with a few simple shares of SPDR S&P 500 (SPY) and iShares Core U.S. Aggregate Bond ETF (AGG).
1. Nearly 100% of returns are directly due to asset allocation.
Most returns are “explained” by asset allocation, in investment parlance. That means it matters more how you divide up the pot into bonds, U.S. stocks, international stocks, etc., than it does whether you pick the best (or worst) funds in each of those asset classes.
To answer the question of how important asset allocation is to overall returns, there are a few ways to slice and dice the data. For individual investors, the salient question is how influential it is to a single portfolio over time. From this viewpoint, a number of trustworthy research studies find that asset allocation explains about 100% of the level of investor returns.
2. Relying on an allocation framework means you can use low-cost investments.
The New York Times article references a recent report by John Bogle, founder of passive-fund provider Vanguard Group, where Bogle calculates that the average fees for active mutual funds are north of 2%. Advisors can charge fees above that, further eroding the growth of your dollars. In contrast, a wide array of passive funds and ETFs are available at a cost of less than 0.5% or even 0.1%, drastically reducing the cut of your portfolio that goes to management.
3. Corporate pensions are a dying breed…and they’re taking their asset allocators with them.
We all know corporate pensions are going the way of the dodo – data from the Bureau of Labor Statistics show that fewer than 20% of private sector companies now participate in defined benefit plans, down from 35% in 1990. But the part we don’t hear much about is that in company pensions, there was an advisor in the background doing asset allocation to ensure the corporate funds would grow enough to fund the future retirement payouts. That means not only is the responsibility for saving falling on our individual shoulders, so is the asset allocation.
4. Stock picking is a losing game for most.
It’s very, very difficult to beat the market as a stock picker. Academic studies show that the average stock picker owns concentrated small cap stocks (i.e. the riskiest type of stock), has turnover of 75% annually in his portfolio (i.e. trades far too often) and generally underperforms the market benchmark while taking on more risk. There are a few real life stock pickers who have consistently high returns, but for most of us, it’s a lot of effort for a mediocre outcome.
5. Simplify and diversify your risks in one fell swoop.
Risk management is a science onto itself. Single-stock risk, country risk, currency exposure, oil prices, duration risk or issuer credit risk…the list goes on and on. By opting out of single name holdings and choosing to allocate to broad asset classes, you can effectively diversify many risks and avoid others for very little effort. That doesn’t mean you avoid the risk of loss. But the best way to offset volatility is to have exposure to countering asset classes – like stocks and bonds – in one portfolio.
6. Long-term framework is better for taxes.
I’m not a tax advisor, but there is one convenient truth about allocation with low-fee investments – it’s long-term. There is very little trading involved as a set-it-and-forget-it strategy. There are still short-term tax effects; dividends and interest from stock and bond ETFs and passive funds pass through to the holders each year, and passive funds may occasionally have turnover that creates a short-term gain. But this is more tax-efficient than a typical active mutual fund, which generates short-term gains with trades each year. And it’s far more efficient than churning your own stock holdings to chase a little extra return. If you aren’t actively trading, and your passive funds aren’t generating short-term trading activity, your tax bill could be better off.
7. No minimum or maximum really applies to this style of investing.
If you have $500 or $5,000,000, you are in the same boat for asset allocation – it’s available to you. Most passive funds have very low minimums; Vanguard offers many funds for $1,000 minimums, and
8. Implementable anywhere, by anyone.
Like the beauty of the no-min-no-max feature, asset allocation is a framework you can use just about anywhere – your 401(k), your IRA, your taxable investment account at any brokerage house. I recommend picking an online discount broker where you have an easy platform to use, and have at it.
9. Make your investments simple and straightforward.
Anyone can make a very decent asset allocation out of three things – cash, bonds and stocks. Pick an ETF for bonds and one for stocks – voila, you have a balanced portfolio. If you want to get more complex, that option is always available, but with two simple ETFs you have done 95% of the work.
10. Low maintenance system with only occasional changes.
Setting an asset allocation is something you only have to do once in a great while. From time to time, you’ll need to rebalance your investments as higher-return categories start to overtake the portfolio. As you get closer to retirement, you’ll want to shift to more conservative and income-generating investments. That’s about it. Make a plan, set it up, and watch your portfolio weather the storms.
Embracing asset allocation as a tool is a simple way to open up efficient, low-cost options for long term investing. And fret not – there will be plenty of other things to blame Wall Street for down the road.