6. Portfolio Rebalancing

February 20, 2011 Leave a comment

This is part six of seven in my attempt to explain how you should invest in your retirement portfolio.  Click here for part five.

In a nutshell, portfolio rebalancing is when you check up on your portfolio at certain intervals of time and make sure that the percentage of each asset class in your portfolio remains close to the percentage that you originally set for it (as discussed in part 3).   Here is a quick illustration: Lets say I bought $1,000 each of two funds for my portfolio – a stock fund and a bond fund – and I want each fund to make up 50% of my portfolio at all times.  After 1 year, my stock fund went up 20% and my bond fund declined 5%.  As a result I had $1,200 in my stock fund and $950 in my bond fund.  My total portfolio value gained a little to become $2,150, but now had 55.8% (1,200/2,150) of my portfolio in stocks and 44.2% in bonds.  Because it is important for me to maintain a 50/50 split in my portfolio to reduce risk I would sell shares of my stock fund and buy shares of my bond fund so that each fund would have half of my new portfolio value which was $1,075 (2,150/2).  This is called portfolio rebalancing.

I’ll admit its not a very sexy topic, but it is one of my favorite parts about retirement investing because it takes the human element out of your decisions.  The beauty of rebalancing is that you never try to time the market, and you never have to guess about where its going.  If you choose to rebalance every year (a good strategy), then you can buy funds in january and not worry about a thing until december comes along.  Then in january you don’t even have to “research” the market, you just buy or sell funds to make sure that all the assets in your portfolio make up their proper percentage.  Why do I love taking the human element out of the equation?  Based on my own experience and plenty of data, we only get in our own way when we try and “time the market.”

Are humans really that bad at market timing? Dalbar Inc. is a Boston based research firm that publishes an annual report called the QAIB or Quantitative Analysis of Investor Behavior.  They charge $99 to see the annual report, so I haven’t seen it with my own eyes, but I did read a book called It’s Not about the Money by Brent Kessel which described a recent QAIB report.   According to the book, the report studied the actual returns of all investors in equity mutual funds from 1987 to 2006.   The report showed that the average investor would add money to their investment account when the market went up, and then take out money when the market went down.   As a result of this behavior, the typical investor grew $10,000 into $23,252 in 22 years.  Over the same time period, the S&P 500 grew $10,000 into $93,050.

In this example we are talking about people who are simply investing in mutual funds – NOT investing in individual stocks.   As I have explained above, mutual funds are essentially index funds, except they have a 1-2% smaller return.  So what this study is really saying is that the reduction in gains is not a result of picking the wrong stocks, but simply buying and selling at the wrong time.  Its just human nature to want to trade too much and  to go after the “hot fund.”  Its almost like we can’t help ourselves from selling low and buying high – and that is why portfolio rebalancing at set intervals is so successful.  You won’t worry about getting in your own way.

Investor opinions during the recent market slump in 2009 and subsequent recovery also provide an excellent example of how challenged humans are in making the correct investment decisions.   According to a Gallup poll from March 4th 2009 –  just a few days before the market bottom  – only 18 percent guessed that the stock market would recover by year end.  As it turns out, the S&P 500 gained 67 percent from its low point on March 9th until the end of the year meaning just 18% of Americans guessed right.  The poll results from the above link are posted below:

How often should I rebalance my portfolio?  I was so in love with the idea of portfolio balancing that I was ready to rebalance my portfolio once a month.  I wasn’t sure how I was going to make the numbers work – because as explained in part 5, the commissions associated with making 10 trades a month were pretty high.  As it turns out, there really is no right answer – there are studies that show monthly rebalancing to be the most effective, and other studies that show annual rebalancing to be most effective.  Still other studies suggest that its not the time period that should trigger your rebalancing but whether your original asset allocation is broken by a certain percent (like 10%).  Regardless of time period or other method you choose to trigger your rebalancing, the important thing is to come up with some way to adjust your portfolio that will take any emotion or attempt to time the market out of the equation.

Based on my research it seems like rebalancing your portfolio annually is a safe approach.  But just because you rebalance annually, it doesn’t mean you should be putting money into your retirement portfolio only once a year.   As I explained at the end of Part 5, once a year investing reduces your return because your money wasn’t in the market getting 8% a year, and is risky because you are not paying yourself first.  So in the end, even after taking into account annual rebalancing, it is still important to put money into retirement once a month – which means there is really no way to avoid paying large amounts of money just in trade commissions.  With this realization I decided to revisit target date funds.

To continue reading, follow the link to Part 7 – The Solution.

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7. The Solution: Target Date Funds

February 16, 2011 2 Comments

This is part seven of seven in my attempt to explain how you should invest in your retirement portfolio.  Click here  for part six.

So what exactly are target date funds (TDFs)?  At their core, TDFs are mutual funds.  But unlike mutual funds which might own individual stocks, TDFs are “funds made up of other mutual funds.”  In other words, TDFs do not directly own individual stocks but instead they own index funds, or a bunch of mutual funds in order to provide the investor an appropriate asset mix for retirement (like the asset allocation strategies mentioned in part 3).  In general, TDFs are composed of four primary asset types: 1. US Equity (Stocks and Real Estate) 2. International Equity, 3. Bonds, and 4. Cash Reserves.   The percentage of the fund’s money in each asset depends on the fund’s target retirement date.

For example, Vanguard has a “2020” fund, a “2025” fund, a “2030” fund…. all the way up to a “2055” fund.  If you plan to retire in the year 2055, you should buy the 2055 fund.  The 2055 fund will have more of its assets in stocks than the 2020 fund because more risk is acceptable with retirement that far off.  But the asset allocation of the 2055 fund will not always remain the same.  An important feature of target date funds is that the asset allocation will change (and become more conservative) as you get closer to retirement without you having to buy  a different fund.  So while the 2055 fund may have 90% of its assets in stocks and 10% in bonds today, in the year 2045, your “2055 fund” will have something like 60% stocks and 40% bonds.

Target date funds were created to be a one stop shop for investors.   You start putting money in to one fund in your 20s, and you will continue to put money in that same fund all the way into retirement.  You don’t have to worry about buying different funds to make sure you have the appropriate asset allocation in your portfolio because your target date fund is automatically diversified and rebalanced every year.  Further more, like mutual funds, you don’t have to pay a trade commission every time you put money into it.  So when I first read about TDFs at my HR orientation, it all sounded too good to be true, and I wrote them off because I figured they would have high expense ratios – just like most other mutual funds.  But after months of research on how to be a do-it-yourself investor using index ETFs, I finally concluded it was impossible to overcome the high costs of making online trades – even if it were as few as 3 trades a month.  If I invested $6,000 a year with my ETF strategy, my retirement portfolio would have an effective expense ratio of 6.92%, meaning I would be better off buying mutual funds.  So as much as I had tried to avoid it, it was finally time to reconsider Target Date Funds.

What are my options?  From what I could find there are three major players in the Target Date Fund world: Vanguard, Fidelity and T. Rowe Price.    Here are links to each fund (that is appropriate for my target retirement) along with their expense ratios:

  • Vanguard’s 2050 Fund (VFIFX): 0.19%
  • Fidelity’s 2050 Fund (FFFHX): 0.84%
  • T. Rowe Price’s 2050 Fund (TRRMX): 0.77%

0.19%!  Needless to say I was shocked at how low Vanguard’s expense ratio was, and honestly a little skeptical.  Just for reference, the weighted average expense ratio of all 10 index funds in my preferred asset allocation (described in part 3) was also 0.19%.  By that I mean if you multiplied the expense ratio of each index fund in your portfolio by its allocation percentage you would get your portfolio’s weighted average expense ratio.  For example, the cheapest Vanguard index fund (I’m using vanguard instead of Schwab because overall having a Vanguard account is the cheaper option) for the “Total Stock Market” is VTI with a 0.07% expense ratio.  The cheapest fund for High Yield Corporate Bonds is HYG with a 0.50% expense ratio.  To get the weighted average you would multiply VTI’s 0.07% by VTI’s allocation percentage (25%), add the product of  HYG’s 0.50% ratio and HYG’s allocation percentage (5%), and on and on for each asset.

Though both Vanguard’s Target Date Fund and my ETF portfolio would have the same expense ratio, it is clear that the Vanguard TDF is a much better deal because I wouldn’t have to pay any money on trade commissions (though I still would have to pay the $20 annual account fee).  Even with the obvious solution in front of me, I was curious to know why there was such a difference in expense ratios for funds that were supposed to do the same thing.

Why do similar target date funds have different expense ratios? If you do a little digging you can find out the composition of each fund.  Each fund is slightly different in how much it allocates to US Equity, International Equity, and Bonds, and each fund shows small differences in how that allocation changes over the years.  I’ve include a table below to show the small differences in each funds asset allocation strategy:

What is more intersting, however, is how each fund accomplishes this broad asset allocation.  As mentioned above, each of these target date funds is essentially a fund of funds.  Take the Vanguard Fund.  It is comprised of just 3 funds: The Vanguard Total Stock Market index, the Vanguard Total International Stock index and the Vanguard Total Bond index.  On the other hand, T. Rowe Price’s and Fidelity’s funds are composed of 17 and 20 different funds, respectively.  The extra funds essentially further divide each of the major categories – like US equities – into sub categories.  For example, Fidelity has 10 different funds that make up its “US Equity” allocation and they are shown in the screen shot below:

I suppose that what you are paying for in the extra expense ratio is having your TDF be EXTRA diversified.  The question then is simply this: Is a three fund portfolio properly diversified?  That is probably a question better debated by academics than myself, but I know I feel pretty comfortable with it, especially when considering the drawbacks of the other two funds.

Both the Fidelity and T. Rowe Price funds are made up of actively managed mutual funds – NOT index funds like the Vanguard TDF.  Take Fidelity’s “Small Cap Value Fund” (shown above) for example.  Its investment strategy is to invest “at least 80% of assets in securities of companies with small market capitalizations,”  and to invest in “securities of companies that [the manager] believes are undervalued in the marketplace.”  This is taken straight from Fidelity’s website.  In other words, some guy is picking and choosing what stocks to be in that fund, and as discussed in Part 2, actively managed funds generally do not beat their relevant indexes.  Furthermore, you’ll note that the “Small Cap Value Fund” is part of the US Equity assets, yet it says in the fund’s prospectus that it holds 5% of its assets in international companies!  It’s hard to feel comfortable with a fund whose real asset allocation is almost impossible to compute, much less decided by active management strategies.

The Decision:  In case it is not completely obvious by now, I decided to take my talents, or my money rather, to Vanguard’s target date fund.  Admittedly, I gave up a few things in making the decision.  First, I gave up on the idea that appropriate diversification meant having 10 different funds in your portfolio.  I could have bought one of the other target date funds with a more nuanced diversification – but as I said, I was not comfortable with buying a fund that was composed of actively managed funds.  The second thing I gave up was approximately $2,100 over 30 years.  As it turns out, I can buy the same three funds used in the Vanguard TDF for free with a vanguard account which would result in a weighted average expense ratio of 0.11% percent, compared to the TDF’s expense ratio of 0.19%.  That 0.08% difference adds up to about $2,100 in 30 years.  The way I justify this expense is that I am essentially paying $70 a year to have someone rebalance my portfolio and automatically change my portfolio’s asset allocation as I get older.  To me, having absolutely no stress and no responsibility for my retirement portfolio is worth $70 a year – it may not be for you.

So thats it.  I went from scoffing at target date funds to being a proud owner of Vanguard’s VFIFX fund – and not because I wanted to, but because that was the smartest (and easiest) thing to do.  Hopefully, I’ve convinced you to do the same, but if not, at the very least I hope that you’ll agree that the logic I used to make that decision is sound.

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Reprise – My 4 Assumptions about Retirement Investing

February 9, 2011 Leave a comment

This is the retrospective piece of my 7 part article on how to invest in a retirement portfolio.  Click here for the original article.

When I began my research into how to invest for retirement, I wasn’t trying to prove a point or convince anyone to use a particular method.  I simply wanted to make the best and most logical investments.  But I have discovered, mostly by talking things over with my friends, that what is best and most logical to me is not always the most logical to everyone else.  As a result of this realization I took a closer at what I had written in an effort to draw out the underlying assumptions of my work.  I determined – after some soul searching – that I have made four basic assumptions about retirement investing that influences every investing decision I make.

1.       Over a 20-30 year period, I will not beat the market with individual stocks.  You can call it low self esteem, I’ll call it smart.  I have neither the time nor the ability to handle the stress required to invest on my own.  Even if I did, the research shows that consistently beating the market is VERY rare.

2.       Mimicking the market’s returns will allow me to achieve my retirement goals.  I firmly believe that I don’t need to hit it big on the stock market in order to be able to retire.   If I can simply match the market’s return I will be able to retire comfortably.  I don’t assume that the market will return 8% over the long run.  That would be nice, but I am comfortable with whatever the market’s average annual return will be.  The way I look at it is this:  if it is rare to beat the market, then matching the market is the best you can do no matter what.

3.       As a passive investor, my role is to minimize expenses.  Since I don’t have to pick funds or individual stocks based on anything other than asset allocation, my only responsibility is to minimize the amount of money taken out of my portfolio by fees.

4.       Investing for Retirement is stressful.  Whether I beat the market every year, match its returns, or loose big,  I will be stressed during every moment that I think about my retirement portfolio.  It is one thing to invest in a discretionary portfolio, its another thing to invest in a portfolio that will be your means of living after age 65.  The importance of the retirement portfolio means that every investing decision has enormous weight – and only compounds my fear of making a decision that could cost me thousands of dollars.  I want to minimize the time (and therefore stress) I spend on my retirement.

Hopefully these assumptions help to explain the thought process I went through on my way to buying a target date fund, but in case its still not clear, here is a recap of how they influenced my research.  Assuming that I can’t beat the market put me on the path towards mutual funds and index funds. Both the  “investing is stressful” and the “average returns will allow me to retire” assumption led me to index funds.  While the second assumption has an obvious connection to index funds, the “investing is stressful” assumption led to this train of thought:  At the end of the day, even if the market averages only 6% a year, I can still look back at my investment decisions and say I did the right thing.  Index investing is the equivalent to being a smart poker player.   Sure, you might occasionally do better if you stayed in a game with a bad hand only to win on the river, but 9 times out of 10, if you play smart and play the percentages, you’ll be the guy at the final table.   Knowing that you made the smartest and safest decision you could helps to alleviate the stress in my opinion.  The third assumption resulted in my obsessive analysis of expense ratios and account fees.  Finally, the “investing is stressful” assumption led to me choosing target date funds over a more time consuming index fund portfolio.  If you are using these four assumptions, I don’t think it is possible to arrive at a solution that is anything other than “buy Target Date Funds.”


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