When most people think of a glide path, they think of an airplane approaching a runway gradually and safely while lining up for a soft and comfortable landing.
Investors need the same. But rather than altitude above ground, investors must grapple with the amount of risk they take on as they age.
To make an extreme comparison, if you lose most of your savings when you’re 25 or 30, there’s a good chance you’ll be able to get it back when you’re ready to retire. But if you lose most of your money at age 55 or 60, you have a much bigger problem.
This article is the seventh in a nine-part series I consider Boot Camp for Investors 2023.
· The first installment was The best way to invest for retirement.
· The second was Seven Simple Portfolios That Have Beaten the S&P 500 by More Than 50 Years.
· The third was How to Control Your Investment Losses.
· The fourth was How to turn small amounts of money into big sums later, and why you should invest beyond the S&P 500.
· The fifth was How to retire even if you are not rich.
· The sixth was This is the best way to start retirement.
· The eighth was published earlier this year: Our recommendations for exchange-traded funds.
A glide path, today’s topic, is essentially a plan for gradually transitioning from riskier investments when you’re young to lower risk investments when you retire.
A very effective way to do this is to rebalance your investments between stocks (higher risk) and bond funds (lower risk) each year as you get older. The problem: few investors will actually do that. We live in a “set it and forget it” world, and we want things to be easy instead of challenging.
Fortunately, there are much easier ways.
The easiest and simplest way is to invest your retirement savings in a fixed-date retirement fund. That way, you’ll own a gradually evolving mix of stocks and bond funds, with a built-in path geared toward the date you select for your expected retirement.
These extremely popular funds also manage multiple risks and provide access to career diversification at relatively low cost without requiring any action from their shareholders. For simplicity and reliability, you need look no further.
And yet, if you want to spend more money in retirement, these funds are designed to be relatively conservative, and their capital allocations typically don’t include significant exposure to asset classes that have produced higher returns in the past, specifically value stocks and small stocks. limit stocks.
A few years ago, Chris Pedersen, director of research at the Merriman Financial Education Foundation, found an easy way to give target-date shareholders a “piece of the action” along with the convenient slide path those funds provide.
He calls this solution “two funds for life,” and has written a book on the data behind his recommendations, which I support. This strategy combines a target date fund with a “momentum” fund that invests in small-cap value stocks, which have the highest long-term performance history of any US asset class.
A basic way to apply this strategy is to invest 90% of your money in a target date fund and the other 10% in small-cap stocks.
“If someone asks me what is the easiest way to invest, that’s the one I recommend,” Chris told me. Compared to a target date alone, that combination “can increase what you have in retirement by about 25% without much additional risk.”
In the video we recorded, Chris showed that increasing the small cap value percentage to 20% could increase lifetime profit by 75% in inflation-adjusted dollars. He might think that moving from 10% to 20% in small-cap stock would mean taking a lot more risk. Chris said it’s not like that.
From 1970 to 2022, the worst drawdown was not much larger than a target date fund itself.
|target date background||Small Cap Value||worst reduction|
|Merriman Financial Education Foundation|
Those figures do not assume a rebalance and are based on the target date background to provide glide path.
Here’s how to prevent the small-cap value fund from becoming too large a part of your portfolio. Multiply the number of years until you expect to retire by 1.5, then let that be the percentage of your portfolio invested in small-cap value stocks.
For example, with 20 years until retirement, 30% goes to the small-cap stock and the other 70% to your target date fund. Repeat that calculation every year, and you have your own personal glide path.
Some investors wonder if they are too old to invest in small-cap value stocks. That is a good question.
In our video, Chris quoted some numbers from Index Fund Advisors, a fee-only wealth management and advisory firm. It turns out that the longer you own small-cap value stocks, the more likely they are to outperform the S&P 500.
As the story goes, small-cap value stocks outperformed the S&P 500:
50.1% of the time in periods of one month;
55.4% of the time in periods of one year;
57.9% of the time in periods of three years;
61.8% of the time in five-year periods;
73.8% of the time in periods of 10 years;
85.3% of the time in periods of 15 years;
practically always (99.7%) in periods of 20 years.
Regardless of what you choose, if you plan to embark on this two-fund strategy, I recommend that you take the time to watch the video that Chris and I recorded.
I also highly recommend Chris’s book, “2 Lifetime Funds,” what he describes as an owner’s manual for this strategy. You can order it on Amazon for a print copy or a Kindle version. Or click here for your free PDF.
A few years ago Richard Buck and I described this strategy in a short book aimed at young investors. Your free copy is waiting behind a link at the bottom of this article.
In the final installment of this series, I’ll recap some of the most important lessons we’ve learned.
Richard Buck contributed to this article.
Paul Merriman and Richard Buck are the authors of “We’re Talking Millions! 12 easy ways to boost your retirement”.