In Chapter 9, we delve into the importance of asset allocation and the pursuit of higher expected returns using academic research to inform our investing strategy.
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Announcer: [00:00:00] Welcome back America to Sound Retirement Radio, where we bring you concepts, ideas, and strategies designed to help you achieve clarity, confidence, and freedom as you prepare for and transition through retirement, and now here is your host, Jason Parker.
Jason Parker: America. Welcome back to another round of Sound Retirement Radio.
So glad to have you tune in into this episode, number 414. In chapter nine, we’re going to talk about why asset allocation is so important, but let’s go ahead and renew our mind before we jump into this episode. Here’s a verse from Ephesians 6, 7, serve wholeheartedly as if you were serving the Lord, not people.
And then of course, with Halloween coming up, I’ve got a couple of jokes for the kids. Why did the headless horseman get a job? He was trying to get ahead in life. What can you catch from a vampire in the winter? Frostbite. All right. In chapter nine, we delve into the importance of asset allocation and the pursuit [00:01:00] of higher expected returns using academic research to inform our investment strategy.
I recorded a video that I’m going to post in the show notes. If you’d like to learn more about our research methodology and our philosophy regarding how to invest in retirement. I encourage you to watch it. It’s important to have a good cashflow plan as you prepare for retirement. And you can use the retirement budget calculator to help you dial in those cashflow numbers.
But once you have the plan in hand, you need to implement an investment strategy and you really don’t want to be trying to figure things out at this phase of life. I hope that once you retire, you’re going to be able to enjoy your retirement without any kind of disruption. However, it’s important to be wise with your investments as an irreversible mistake could have a significant impact on your financial wellbeing.
To attain success, one must possess a well crafted plan, an astute investment strategy, unwavering discipline, and a touch of optimism. A great plan and investment strategy are [00:02:00] not something you do just once and then you forget about it. You really need to make adjustments as you go so as to make sure that you’re staying on course for your destination.
Next week I’m going to reveal Chapter 10, where we look at rebalancing. Let’s get started. Chapter 9, why asset allocation is so important. As I’ve met with people around the country, I’ve found that many people don’t have an asset allocation strategy. Many people have only made investments in various stocks, bonds, and mutual funds with no real guidance on portfolio construction or asset allocation.
They just know that they should have some money in stocks, some money in bonds, and some cash, which is a very basic understanding of asset allocation. Let’s explore why this subject is so much more important than just that simple structure. Risk is different once you retire, as you’re no longer saving and accumulating.
And as I’ve said before, during that time, risk was just noise. But if anything, volatility helps you accumulate wealth because when you’re making regular [00:03:00] contributions and dollar cost averaging into the market, volatility allows you to buy during the I’ve heard the analogy that investing is like climbing Mount Everest.
Climbing Mount Everest would be like the accumulation phase, whereas the distribution phase would be like coming back down from the peak. An interesting statistic is that most people die coming down Mount Everest than going up. In an article by Scientific American, it said that only about 15 percent of deaths occur from attempting to scale Mount Everest, whereas 56 percent of the deaths occur on the way down.
The analogy helps us to understand that sometimes the way down or the distribution phase in a retirement plan can be more important and risky than the way up or the accumulation phase. Let’s look at the distribution of wealth, which is different from how most people think. Many of the investment podcasts that I listen to are focused on the accumulation of wealth.
Well, only a few talk about portfolio distributions or [00:04:00] how asset allocation is applied in the distribution phase of retirement. Let’s start with answering one of the most basic questions. What is asset allocation? Asset allocation is balancing risk and reward by investing in different asset classes with the expectation that they don’t all move in tandem.
It’s finding the sweet spot on the efficient frontier that maximizes returns for a given level of risk. An overly simplistic example of asset allocation would be to determine how much to hold in cash, bonds, and stocks. Asset allocation even more simply means not having all of your eggs in one basket.
To create an asset allocation strategy, you would want to understand what rate of return is required to meet your future cash flow needs. You’ll also want to know how different asset classes have performed historically. Lastly, you’re going to want to make some forward looking assumptions about how the asset classes will perform in the future.
Asset class diversification. Now that we have an idea of how to [00:05:00] define asset allocation, why do we say it’s important in the first place? Well, this all started back in 1986 with the BHB study. that we mentioned in chapter eight. In that study, they concluded that asset allocation explained 93. 6 percent of the variation in a portfolio’s quarterly returns, while stock picking and market timing played minor roles.
Some of the more recent discussions around this early work are that its focus was on the variability of returns, not on return levels or relative performance, which is what most investors are interested in. It’s the academic community that has informed our understanding of the importance of asset allocation.
It’s also important to take a moment to talk about diversification, because I think that’s another word that gets used regularly, but I think of diversification differently than I think of asset allocation. Especially in a retirement portfolio, I define diversification as a withdrawal strategy over time and risk levels.
Essentially, diversifying your [00:06:00] investments for retirement cash flow planning, assuming that cash flow planning is the process of identifying future income, expenses, and major expenditures so that they are coordinated with the investment planning. The first step is to diversify the time horizon based on when you’re going to need the money.
Then, depending on how long before you need access to the investments, we would determine how much risk you should take for each time segment. Once we know how much you plan to spend, we can create each time segment. We would then create an asset allocation strategy to match up with each of those time segments.
The segment needed in the early years would be invested more conservatively, while the segments that are needed in the later years would be invested more aggressively. This concept seems fairly easy to understand, and from my experience, a lot of people like the idea. They think it makes sense. Now that we know what acid allocation is, and why it’s important to look at it, let’s look at how this applies to you as you shift from making the transition from the [00:07:00] accumulation phase of acid allocation into the distribution phase of acid allocation.
In the next few paragraphs, I’m going to discuss the Callan Periodic Table of Investment Returns, and it might be easier to follow along if you do an internet search for Callan Periodic Table so that you can view the chart. I’m going to do my best to describe to you what I’m looking at, but if you’ll imagine a spreadsheet or a grid or a table, if you will, along the top of the spreadsheet are columns, and each column represents a year starting with the year 2000 and going through the year 2019.
Although this chart is updated yearly, in each row of the columns are colorful little boxes, and each of those boxes represent an asset class and how it performed for that year. Each asset class has been assigned a color so it can be tracked more easily, visually across the years. The asset classes being represented are as follows, real estate, U.
S. fixed income, cash, small cap equity, Global [00:08:00] fixed income excluding the United States, high yield, large cap equity, international developed excluding the United States, and emerging markets. This colorful table illustrates that no one asset class is consistently the top or the bottom performer. But if you’re like me, what you try to do is recognize patterns.
And you think to yourself, boy, if I could just identify the asset class that’s consistently at the top, wouldn’t that be a winning strategy? Or maybe just avoid the asset classes that are consistently at the bottom. And I think the chart does a pretty good job of showing you why trying to play that game is not going to get you very far.
Here are a couple of things that I noticed as I looked at the top and bottom performers over this period from 2000 through 2019. At the very top, the asset classes that consistently showed up the most include real estate, which was the best performer. It showed up five times out of the last 20 years.
Emerging markets also [00:09:00] showed up five times. U. S. fixed income showed up three times, as did small cap equity. Large cap equity was in the top spot twice. Global fixed income and cash were each in the top spot once. As I look at the bottom performers over this period, cash was the worst performer eight times over this 20 year period.
Emerging markets were there four times. Global fixed income and developed international, excluding the United States, were both there twice. And large cap equity, U. S. fixed income, and real estate were all there once. The power of looking at the Callen Periodic Table of Investment Returns helps you to understand that it’s going to be a really tough game if you think you’re always going to pick the best performing asset class each year.
What it encourages you to consider is that instead of just trying to pick the best performer, wouldn’t it be more advantageous to broadly diversify your holdings across all of the different asset classes and then rebalance? Rebalancing, as discussed previously, [00:10:00] forces you to sell some of the positions that have done well in the good years and buy more of the positions that have done poorly.
It’s counterintuitive. It forces you to think different about the market. It forces you to think differently than the way that most people want to think. People want to hold on to their winners and sell their losers. And when you rebalance a portfolio, it’s forcing you to do the exact opposite of that.
It’s important to understand that we’re talking about asset allocation for people who are transitioning into retirement. The advice that people who are accumulating wealth are given is likely not going to be the same for people who are making the transition into the distribution or retirement phase.
What got you here might not get you there. In the analogy about climbing Mount Everest, while there is certainly a risk, the accumulation phase doesn’t feel as daunting when you have a job and you have income coming in. But suddenly when you’re heading back down that mountain, and now what you’ve saved is what you’ve saved, you have to make that money last for the rest of your life.
That is not a time to be experimenting with what [00:11:00] you think is going to work. You have to have a good disciplined strategy, keep your fees as low as possible, choose the asset allocation that’s going to work for you, and diversify your money across time segments. That’s what I would encourage you to consider.
So here are a few questions that I think are worth asking yourself as you begin to make this transition. Why did you select your current asset allocation strategy? What was the methodology used for creating your asset allocation strategy? Was there a methodology? Is your asset allocation strategy designed for an accumulation strategy, or is it designed for a distribution strategy?
What did you design it for? Factors. One of Eugene Fama’s most significant contributions to investing has come from his collaboration with his colleague Kenneth French and their work in the development of factor models for investing and their contribution to portfolio construction at Dimensional Fund Advisors.
Asset allocation models based on factor based framework have become [00:12:00] incredibly popular in the investment community, and many investors are wondering whether or not they should incorporate factors into their retirement investment framework. Who are Eugene Fama and Kenneth French? Eugene Fama is an American economist who currently is a professor at the University of Chicago Booth School of Business.
Fama is best known for his work on asset pricing and portfolio management. Kenneth French is an American economist who is currently a professor at Dartmouth College. French is best known for his work on factor models, asset allocation, and mutual fund performance. FAMA and French rank within the top 10 most cited fellows of the American Finance Association, recognized for their work in financial science.
Both FAMA and French are on the Board of Directors at Dimensional Fund Advisors. What is factor research? Factor research is a way to organize historical data to try and understand what drives differences in returns across different groups of securities. From this research and these models, you can [00:13:00] glean insights about drivers of expected returns and differences in the risk across different asset categories.
The three original factors are market risk, size risk, and value risk. Market risk is the risk that cannot be diversified away. Size risk is the risk associated with small capitalization stocks. Value risk is the risk associated with stocks that are trading at a low price to earnings ratio or low price to book ratio.
Factors such as momentum, profitability, and value. and investment have also been identified. Small companies have higher expected returns than large companies. In the early 1980s, David Booth, who had completed his MBA at the University of Chicago and who had been a student of Eugene Fama, identified that there were not many strategies that targeted the returns of small cap stocks.
There was evidence at the time that smaller cap stocks had higher average returns historically than large cap stocks. [00:14:00] And the expectations were that there would be higher expected returns going forward. So Booth, the co founder of Dimensional created the Dimensional US micro cap portfolio, arguably the first systematic factor based investment strategy for institutional investors.
The strategy focused on small cap stocks, which have historically outperformed their counterpart, large cap stocks. Value over growth or low price equals higher expected returns. Another factor includes a company’s value, which can be derived from a company’s financial statements. These can include a company’s market price, which is determined by looking at price to book ratio, price to earnings ratio, dividends, and free cashflow.
Generally, companies are categorized as being either growth or value. Growth companies tend to have higher price to earnings ratio, have a greater focus on reinvesting earnings into assets, and don’t usually pay dividends. Value companies tend to have lower [00:15:00] price to earnings ratios with less of a focus on asset growth and pay dividends.
Value stocks have historically outperformed growth stocks. However, there have been extended periods where growth stocks have outperformed value. Investment returns. Factor investing takes into consideration at a given price, how much an expected return an investor can expect, given a company’s cashflow and profitability.
Research done by Dimensional has shown that companies with larger investments or asset growth on their balance sheets tend to decrease expected returns for investors, and that’s why As compared to companies with smaller investments. Historically, business with high asset growth or investment have had lower returns than businesses with lower asset growth as such dimensional has explored strategies that take into account the asset growth of companies, finding that excluding small.
High asset growth firms has resulted in increased value in portfolio strategy. An [00:16:00] example can be found in a simulation run by Dimensional, which explored the impact of excluding firms with high asset growth in the small cap market using data from the U. S. small cap market from 1974 through 2018. What they found was that excluding growth firms with low profitability and high investment resulted in a return of 14.
49 percent as compared to an overall small cap market which returned 12. 65%. A similar pattern was observed in international markets as well as emerging markets, all of which had experienced greater returns with the exclusion of small, high asset growth firms and low profitability growth companies.
Profitability premium. In addition, a business’s profitability is another key factor when investing. Given the extensive amount of research on using profitability to increase expected returns, investors need to take notice of this factor when making investment decisions. [00:17:00] Professors Eugene Fama and Kenneth French are credited with taking financial data that is observable and using it to find information about expected future profitability for companies.
Their research showed that a business’s current profitability can tell us about its profitability for years to come, thereby helping predict the success of a company’s stock or the investor’s expected return in the long run. Building off the Fama and French influential findings, Professor Robert Navimarks, a world renowned expert on empirical asset pricing, explored the relationship between different measures of current profitability to stock returns.
An important insight that Navimarks found was that in taking a company’s profits, Not all current revenues and expenses have information about future profits. He found that firms sometimes have revenues or expenses that are extraordinary, which they don’t expect to reoccur. Accounting for these anomalies, Navimarks utilized national data from the [00:18:00] 1960s through 2013 that excluded non reoccurring expenses or revenue and revealed a strong connection between current profitability and future stock returns.
He discovered that firms with better profitability had higher returns than those with less. Research by Dimensional further confirmed NaviMarx’s work. Data taken from the Dimensional high versus low profitability indices have shown that from 1964 through 2016, The high profitability index had an annual compound returns of 12.
55 percent as compared to 8. 23 percent for the low profitability index. The same pattern was found in international markets as well as emerging markets with high profitability firms outperforming low profitability firms. In conclusion, investing doesn’t have to be a guessing game. And rational decisions can be made backed by data and research done by those in the academic community.
You can’t expect that picking [00:19:00] individual stocks will generate superior returns. Broad diversification is an intelligent way to reduce risks when investing, and insights from the academic community show you. The developing investment portfolios based on financial science can yield the desired results for individual investors seeking higher expected risk adjusted returns.
Looking at factors such as size, value, investment, and profitability have shown to be important and reliable drivers of higher expected returns. Vanguard offers low cost market cap weighted index funds and dimensional offers what I would call enhanced index funds that incorporate financial science to tilt portfolios with higher expected returns by using factors.
You can combine both Vanguard and dimensional funds to enjoy low costs, broad diversification, and academic research to increase confidence in your retirement investment strategy.
Announcer: Information and opinions expressed here are believed to be accurate and complete for general [00:20:00] information only, and should not be construed as specific tax, legal, or financial advice for any individual, and does not constitute a solicitation for any securities or insurance products.
Please consult with your financial professional before taking action on anything discussed in this program. Parker Financial, its representatives, or its affiliates, have no liability for investment decisions or other actions taken or made by you based on the information provided in this program. All insurance related discussions are subject to the claims paying ability of the company.
Investing involves risk. Jason Parker is the president of Parker Financial, an independent, fee based wealth management firm located at 9057 Washington Avenue Northwest. For For additional information, call 5046 or visit us online at soundretirementplanning. com.
