​Two Funds for Life

Paul Merriman  |


Building on two recent articles, I’m now ready to propose a life-long, low-cost investment strategy that I believe is likely to produce superior long-term returns without much attention from you.

This strategy has two building blocks. First is a target-date retirement fund chosen to approximate the year in which you expect to retire. Second is a “booster” equity fund to provide an increase in your long-term return.

In the first article of this three-part series I wrote: “For investors who want to make a single investment decision that is likely to serve them well the rest of their lives, a target-date fund is a terrific product.”

As I pointed out in the second article, target-date funds are not quite enough by themselves to produce what I want from this strategy.

By itself, a properly selected target-date fund may be “good enough,” if that’s what you’re looking for. It will provide a mix of investments that’s very likely to grow over time. And it will gradually become more conservative as you get closer to your retirement age.

The target-date fund will do all this without requiring any attention from you, and at a relatively low cost. You can set it, forget it, and know that your savings are being professionally (although not individually) managed for long-term success.

However, if your investment strategy ends here, you will miss out on an opportunity that’s likely to produce significantly higher long-term returns with very little extra risk.

Target-date funds deprive investors of the opportunity to take advantage of small-cap stocks and value stocks, two asset classes that over the years have produced much higher long-term results than the large-cap growth stocks that make up most of the equity part of a typical target-date fund’s portfolio.

This leads to the second building block of my proposed strategy: an additional fund (either a mutual fund or an exchange-traded fund, or ETF) that can provide that kind of growth.

The target-date fund becomes the “core” of your portfolio, and the booster fund is likely to provide a higher long-term return.

Exactly how you implement this strategy will depend on your age and how much additional risk you are willing to take in order to improve your returns.

Two years ago I met an investor who is very good with numbers and who shares my passion for helping people get superior returns without undue risks and complexities.

His name is Chris Pedersen, and we focused on how investors in target-date funds can take advantage of three asset classes: small-cap blend stocks, small-cap value stocks, and large-cap value stocks.

I gave him this challenge: Figure out a way that a target-date fund investor can add any or all of these asset classes to a retirement portfolio without losing the advantages of the target-date concept. And make it easy enough that anybody can do it.

It’s generally agreed that small companies as a group are likely to produce higher returns than large companies, though it’s impossible to say how much higher.

The same holds true for value companies.

Small-cap value seems like the best asset class for meeting the challenge I gave Chris.

He concluded that it makes sense for young investors to have a high percentage of their portfolios in small-cap value stocks and for older investors to own less of them.

Chris devised a simple mechanical formula for making this happen.

It works like this: Multiply your age by 1.5, then use the result as the percentage of your portfolio that belongs in the target date fund.

For example, at age 20, you would have 30% of your portfolio in a target-date fund and the other 70% in a small-cap value fund.

When you are 40, 60% of your portfolio would be in a target date fund, with the rest in a small-cap value fund.

Under this formula, by the time you reach age 67, all your money would be safely in the target date retirement fund.

As you can see if you study an article by Chris (link below), long-term studies show that the simple addition of a small-cap value fund would be expected to produce about 50% more money at retirement, with very little additional risk.

Before you dismiss this proposal as too radical, I hope you will check out an article I wrote in 2015. It is based on data through 2014, but it contains a link to data that goes through 2017.

The data through 2014 and the data through 2017 are slightly different, but they lead to the same conclusion: A simple four-fund portfolio turned in far better medium-term and long-term performance than large-cap blend funds that play a big part in most target-date funds.

Measured over 15-year and 40-year periods, which should be of the greatest interest to most retirement plan participants, the four-fund combination left the large-cap blend fund behind.

There’s lots more to say about this. I am writing a book (it should be available sometime in 2019) that will detail this plan with more variations, including lots of data to back up my suggestions.

For now, I invite you to dig into the details of what Chris and I have found. Here are three ways to do that.

First, Chris has written a detailed article, illustrated with some interesting tables and graphs, and you can find it here.

Second, Chris and I have recorded a video on this topic. And third, I have recorded a podcast as well.

We’re proposing a very simple step, and if the future looks anything like the past, taking that step could have a huge long-term impact on the resources you will have available at retirement.

I hope you’ll seriously consider taking that step.

Richard Buck contributed to this article.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not necessarily represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer.

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