Take risks in life, for savings choose a balanced fund
Many of us read one or two investment books, and take away that younger people should take more risk. If you buy a “target date retirement” fund in your 20s, you might end up invested 85% or more in stocks.
If you’re in the tech industry, young, fired up about entrepreneurship, immune to risk — you might be even more open to this message than the average person.
While younger people can afford to invest more money in risky assets, I don’t believe that they should.
You should not go as high-risk along the efficient frontier as your time to retirement theoretically allows.
Here’s an example plan that would work well for many people’s retirement money, to show what I mean. After the plan, I’ll explain why I like it.
- Select a balanced portfolio of 60%, 40%, or 20% risky assets (such as stocks, commodities, high-yield) and the rest in high-quality bonds. Choose 60% or 40% based on how comfortable you are losing money. Choose 20% risky stuff if you’re near retirement.
- Save until you have at least 25 times your annual income dedicated for retirement, then you can stop. The rule of thumb for withdrawing money without running out is 4% per year. Once you can do this, you don’t need more (for retirement), though more would add extra safety. You could also add safety by continuing to work while your investments grow, not continuing to save, but not withdrawing anything either. If you have spending goals other than retirement – a house, college funds – money saved toward those goals doesn’t count toward your 25x.
- Save as much as possible, via automatic withdrawal; if less than 10% of your income, you’re hosed, and more is better. Saving less money is too risky. You’ll need money for goals other than retirement. Your working life might not be as long or as highly-compensated as you expect. If you’re living so close to your means that you’re saving only 5%, it’s too easy to slip beyond your means. You probably can’t get your employer’s full 401k match at only 5%, either. How much you save matters far far far far far more than what you invest in. Investments do not have lottery-like results. Stop thinking that way. If you aren’t saving enough, ratchet up by 1% of income or the amount of any raise, every year, until you are.
- An ideal balanced portfolio would be a single fund. This forces you to look at your investments as one big bucket, eliminating mental accounting. It ensures you rebalance continuously, something it’s tough to do otherwise. More funds might be OK if you have a financial planner who automatically rebalances for you.
- An ideal balanced portfolio includes lots of asset classes. For example, both US and international stocks, government bonds, inflation-protected bonds, high-yield bonds, commodities, etc. … as long as they’re all in one fund and aren’t creating complexity for you. Don’t overcomplicate it and add more mutual funds to get exotic asset classes. “Just one fund” is a bigger win than owning all this stuff.
The balanced fund approach works in real life, with real emotions, and real unexpected circumstances. Here’s why:
- Focus on your life. Maybe it’s a startup, maybe it’s art, maybe it’s children. Risky and/or complex investments are distracting. You have better things to do.
- The goal is to have enough. Enough is not the same as the maximum possible. Investment books keep talking about “beating the market” – that has nothing to do with anything. You care about absolute returns, not relative. Losing 35% instead of 40% … congrats, you beat the market.
- The extra returns aren’t as high as you think. Vanguard has a nice page showing how asset allocations worked out historically. Even using those numbers, the extra risk just isn’t worth it (8.7% vs. 9.9%). But there’s a strong argument that those numbers are misleadingly high. And these numbers neglect your counterproductive behaviors, which will include failure to rebalance, buying low and selling high, and losing motivation to save, among others. Those counterproductive behaviors negate the extra returns — and then some.
- You don’t need to take the extra risk. If you’re saving enough to handle adverse scenarios (unexpected life events, ugly macroeconomic events, questionable government policies) then you’re saving enough to be fine with a good, but not “maximum possible,” rate of return. So optimize to be sure you get the good rate of return, consistently. The question is how much risk you need to take, not how much you could probably get away with. If you have a reasonable plan overall, including an adequate savings rate, there is no way you need to max out your risk. If your plan relies on maxing out risk to succeed, it’s a risky plan, right? Choosing a risky plan is dumb. Reducing uncertainty is more important than maximum theoretical returns.
- Extra risk will cause you pointless angst and pain. It is not human nature to think “I’ve been miserable opening my 401k statement for years, but it will all work out over a 30-year horizon.” You are not a robot. Be sure your savings balance will be going in the right direction as often as possible. (Granted: it’s tough to be making slow and steady progress in those years when the crazy speculators are doing well. But a 60/40 portfolio will still be doing very well in those years, just not insanely well, and you’ll be auto-rebalancing to harvest some of the high numbers while the getting is good.)
- Nobody has a 30-year time horizon (and knows for sure that they do). Risky portfolios only win on average, over very very long times such as 20-30 years. Emotionally, nobody’s time horizon is that long. Practically, nobody knows the future: whether they’ll have an emergency, become disabled, get a divorce, have children, or what will happen to the world economic and political situation. Or on the positive side, maybe you want to retire early or change careers. A 30-year time horizon is a fairy tale.
- Motivation. With an overly risky portfolio, you can be saving 10% per year and still spend a decade with 0% growth in your account balance. What does that do to your motivation to save more money? Savings rate is far more important than investment returns, so stay motivated to save.
- Narrow down the choices. If you’re trying to decide between 35% and 40% stocks, you’re a victim of false precision. It doesn’t matter. Narrow down the choices to 20%, 40%, or 60% stocks. Less than 20% starts to be risky in itself (inflation, or a bad decade for bonds). Over 60% is too risky to be required for any reasonable plan. Tuning more precisely than 20% increments is false precision. So pick from the three options. More options creates paralysis.
- If you’re a risk-seeker, stable savings allow you to take risks elsewhere in life. Join a startup. Move across the country. Take a sabbatical. Even go to Vegas. Whatever. If you don’t have any savings, lots of great experiences may be out of reach. Real life risks are more emotionally rewarding, and often more profitable, than treating your investments like a casino.
Here are a few related thoughts and implementation tips:
- Index funds are cheaper, but low expenses can’t compensate for complexity and emotions. If you have to pay extra to get on autopilot, I say do it. For example if your retirement plan has a well-regarded, actively-managed, well-diversified balanced fund and a collection of single-asset-class index funds, I’d take the actively-managed diversified fund rather than messing with a collection of index funds. If your plan has a well-diversified, balanced index fund, that’s awesome. Here’s a previous post on index funds.
- Investment and savings decisions should use rules of thumb, not precise calculations. It’s easy to read a book about financial theory and then use some software to run complicated scenarios where you plug in your savings rate, your salary, future inflation, future equity returns, future bond returns, future tax rates, future health care costs, future social security payouts… waste of time. Small tweaks to these numbers change the outcome dramatically and nobody has any idea what the real future will hold. (If you must use a complex calculator, use one that simulates a “worst case,” and plan for that.) Avoid precision bias. Because of compounding, small changes in rate of return or timing of cash flows lead to huge changes in end result. This makes financial calculations dangerous tools in support of wishful thinking.
- Target-date retirement funds can be used as balanced funds. Your retirement plan may well lack a balanced fund, but you can often use a target date fund instead; choose one that will have about the right stocks/bonds allocation over the next decade, rather than choosing according to the date (a date-based choice will be too risky). Revisit your choice in ten years after the target date fund has shifted its allocation.
- Please don’t invest your retirement savings in company stock. Especially if you have restricted stock or options outside the retirement plan.
- Risk is risk. Don’t start abstracting it into something theoretical like “volatility.” Risk is the risk you don’t reach your goals. The idea is to minimize the risk of missing your goals. Too conservative a portfolio makes it harder to reach your goals; too aggressive a portfolio makes it harder to reach your goals. Go with Goldilocks here.
Balanced funds used to be the norm, before the financial industry took off and grew enormous. They’re simple, practical, and time-tested. They’re compatible with how your brain works. They ought to be the default for long-term savings (though other approaches have a time and a place).