What's the Point of Investing?

Half of the observations will rise above the central tendency and half will fall below. And most economists are projecting 21st century asset returns that are significantly less than 20th century asset returns, so using 20th century return projections will likely result in a failure rate higher than 50%. Sad!

What about the myth that if asset returns disappoint over the first few years, a client can simply continue saving the same amount if they can have patience and wait for markets to recover? This advice makes me feel good and is valuable to clients who want to panic after a bear market, but it isn’t statistically accurate.

If a client gets unlucky and returns fall below projections, then the probability of meeting their long-run goal has changed. They either need to save more, reduce their required probability of success or reduce the size of their goal.

The client whose portfolio lags behind return expectations can choose to take more risk in order to meet their long-term goal with the same savings rate. But taking more risk means an increased probability that the client will get nowhere near their goal. Doubling down in Vegas is one way to break even, but it’s not a great strategy for retirement.

According to Suri, “If you’re underfunded relative to your goal, then you have two choices. You can improve your situation by taking risk or you can lock in your underfunding. It’s up to you to decide whether to take more risk or contribute a higher amount. There is no magic bullet that will kill the underfunding.”

As clients moves toward their goal, 80% of the time they will either be on track to meet their goal or be overfunded if they have received higher than expected returns. Suri believes that this is the time for advisors to begin discussing the possibility of de-risking an investment portfolio by locking in the goal amount with bond-like assets.

If you’re winning a race, it makes sense to be extra careful as you get closer to the finish line. The same is true with financial goals. “As you get closer to when you need the money, your risk aversion tends to go up” explained Suri. “That’s rational in my view because the time horizon is shrinking.”

Portfolios in Practice

In a traditional mean-variance modern portfolio theory framework, investment selection is pretty straightforward. Assess a client’s risk tolerance and build a well-diversified portfolio. Fill tax-sheltered accounts first, then save in taxable. Rebalance.

Goal-based investing is more siloed, but potentially more effective. The investment objective is to achieve the highest expected net (after-tax) annual return on an investment for a given level of risk in meeting a client’s long-term goal.

How does one achieve the highest expected return? Make sure that the portfolio risk matches the time horizon of the goal. And make sure that the tax sheltering strategy is optimal for the time horizon and for the current and future tax environment of the client.

Although it isn’t that controversial among advisors, matching asset allocation to a client’s time horizon is quite a controversial topic among academics. Theoretically, stocks shouldn’t become less risky the longer you hold them.

Risk means that the distribution of outcomes should increase over time. If stocks have a higher average return than bonds, then a stock investor will usually beat a bond investor, but this will be offset by some really dramatic long-term losers.

In truth, there haven’t been that many time periods where stocks were losers when held for a long period of time — and not just in the United States. David Blanchett of Morningstar, Pfau and I found that this so-called “time diversification” effect occurred in 18 out of 20 countries. The only country where equities really had a rough time relative to bonds over longtime horizons was Switzerland. We estimate that investors would be significantly better off if they increase their portfolio risk for long-run goals.

Why does this matter in goal-based investing? Because a long-term investor could assume a higher expected portfolio return from investing in stocks at the same level of acceptable risk.

In other words, they could reach the same $2 million goal by saving less each year if they’re willing to accept greater investment risk. This sounds like a pretty sweet deal. The investor can meet their goal and the advisor adds value by helping them maintain a healthy allocation to stocks over time.

Assets & Advice

Scott Cederburg, an assistant professor at the University of Arizona, recently co-authored a paper soon to be published in the Review of Financial Studies that discusses whether investors can rely on stocks being less risky in the long run. According to Cederburg, “We don’t have many observations of what can happen over 20-30-year time periods.”

Since we don’t fully understand what drives the observed time-diversification effect, this means that “risk-averse investors would optimally invest somewhat less in stocks once they take the additional uncertainty into account, which would help to guard against the possibility of an extended downturn in stocks,” he says.

How would Cederburg counsel advisors who are developing portfolio strategies for long-term investors? “I would tend to advise younger clients to invest somewhat more in stocks compared to shorter-horizon investors,” he explained, “but the answers are not quite as obvious as the conventional wisdom may suggest.”

Thus, the practice of recommending riskier portfolios for long-term goals is reasonably solid, but certainly not settled science. On the other hand, the benefits of basic portfolio strategies on tax efficiency are considerably more reliable and the nuances are often underappreciated.

What does it mean to build an optimal asset location strategy? A spending goal is in after-tax dollars. And $2 million in a 401(k) is not the same as $2 million in money that can be spent on a retirement lifestyle. If all goals are after tax, optimal asset location means finding the account that provides the highest after-tax return given the time horizon of the goal and the estimated tax rates today and in the future.

This isn’t easy, and we’ll save the details for a future column. Suffice it to say that time horizon and tax rates over time affect the performance of investments held within tax-deferred or tax-exempt accounts, and an advisor can add significant net portfolio performance by understanding the mechanics of asset location.

Since goal-based investing is more complicated, why do it? Why not just recommend a mix of funds and focus on then managing growth over time? Because that’s probably not what most clients are looking for. They’re not just investing to grow assets, they’re investing for a purpose. Not only is the advisor making better recommendations, they’re also helping their clients understand why they’re saving and what it means to take risk.