MW 100% stocks for retirement? A new study says dump the 60/40 portfolio and target-date funds.

By Robert Powell

An all-equity portfolio, with a focus on international stocks, could be the key to maximizing retirement wealth, research suggests.

Forget 60/40. Goodbye, target-date funds. So long, bonds.

An all equities portfolio is the far better way to build the largest nest egg possible for retirement; to generate a larger paycheck in retirement; to make sure you don't run out of money in retirement; to create the largest possible bequest for your loved ones.

Invest 100% of your savings earmarked for retirement in equities: one-third in U.S. stocks and two-thirds in international stocks.

Crazy, right? Not according to Aizhan Anarkulova, an assistant professor of finance at Emory University's Goizueta Business School and co-author of Beyond the Status Quo: A Critical Assessment of Lifecycle Investment Advice.

In their study, Anarkulova and her co-authors challenge two core principles of life cycle investing: first, the idea that investors should diversify primarily through a mix of stocks and bonds; and second, the notion that equity allocations should decrease as investors age.

"We find them not to be true in our setting and I'll tell you why," she said in a recent interview.

For starters, neither of those core investing strategies creates what Anarkulova describes as the most optimal portfolio, a portfolio that will maximize "retirement consumption," a portfolio designed - when factoring in Social Security as well bequests - to give one the highest sustainable income in retirement.

Read: 'My peers have 10 to 20 times more set aside for retirement': I'm 67 and have $100,000 saved. I want to retire in three years. Can I do it?

Save less

In their paper, which will be presented at an upcoming American Finance Association conference in January, Anarkulova and her co-authors studied in their base case a hypothetical couple from age 25 until death who saved and invested using three different strategies, the optimal portfolio, a 60/40 portfolio and a target-date fund $(TDF)$. And what they found is this: Investors following their optimal one-third/two-thirds investment strategy and saving 10% of their income each year can achieve the same financial benefits in retirement, including spending and leaving an inheritance, as a couple using a balanced strategy who saves 19.3% of their income-nearly double the amount.

And while TDFs might seem better than a fixed-weight strategy because they adjust investments with age (as conventional wisdom suggests), they still fall short. To match the financial benefits of the optimal equity-focused strategy, a couple using a TDF would need to save 16.1% of their income-61% more than the optimal strategy requires.

Accumulate more

In their study, Anarkulova and her co-authors looked at what drives financial success in retirement by focusing on four key outcomes: how much wealth people have when they retire, the income they can generate during retirement, how well they preserve their savings, and the amount they can leave behind as an inheritance.

And what they found is that an all-stock investment strategy outperforms typical default investment options, like balanced 60/40 funds and TDFs, in growing wealth over time.

On average, the optimal portfolio, which is rebalanced monthly, produces 50% more retirement wealth than a balanced fund and 39% more than a TDF. And this extra wealth translates into higher retirement income for those who follow the all-stock strategy, according to Anarkulova.

Read: A retirement expert's best advice? Don't retire.

Avoid running out of money

Surprisingly, an all-stock strategy also does better than typical default options when it comes to preserving savings. Couples investing 33% in domestic stocks and 67% in international stocks are much less likely to run out of money. Using the common 4% retirement spending rule, a balanced fund has a 16.9% chance of depleting savings, and a TDF is worse at 19.7%.

In contrast, the all-stock strategy has only a 7.0% chance of running out of money.

"The fact that the all-equity strategy does well in long-term appreciation is unsurprising, given the high average returns on stocks relative to bonds and bills," the authors wrote in their paper. "What is perhaps surprising is that the all-equity strategy, maintained throughout the entire lifetime, easily beats the QDIA strategies in capital preservation during retirement."

According to the Labor Department, a qualified default investment alternative, or QDIA, is a default investment option in 401(k) plans that meets specific criteria. The DOL has identified four types of investments that can qualify as QDIAs: TDFs or life-cycle funds; professionally managed accounts; balanced funds; and capital preservation products.

The optimal strategy leaves much larger inheritances than a balanced 60/40 fund and a TDF, said Anarkulova.

International stocks are better diversifiers than bonds

Anarkulova also noted the reasons why international stocks are far better to use in a portfolio built for a long-term horizon than bonds because of the correlation differences with domestic stocks.

According to Anarkulova, the correlation between bonds and domestic stocks should not be evaluated solely using monthly data, as this doesn't reflect the long-term investment horizon. When accounting for a 30-year holding period, the picture changes significantly.

On a monthly basis, the correlation between bonds and domestic stocks is low at 0.2, which makes them a useful addition to a portfolio under a mean-variance framework, despite their lower returns and standard deviation. However, over a 30-year period, the correlation rises to 0.5, reducing the diversification benefit they provide.

What's more, while bonds are traditionally considered a 'safe asset' in theoretical models, they are not safe in real terms, Anarkulova said. Over a 30-year horizon, their correlation with inflation is strongly negative, at -0.7, indicating that inflation consistently erodes their value. Bonds also lack the high returns of stocks, which might otherwise offset these losses.

Thus, to achieve effective diversification, international stocks are a better option. Their correlation with domestic stocks is 0.3 on a monthly basis and remains relatively stable over a 30-year horizon. Additionally, they offer a natural hedge against domestic inflation in the long run.

Investors typically seek a low or negative correlation between assets in their portfolio, as this is the most effective way to minimize risk while preserving potential returns.

Drawdowns

Investors who choose to use the optimal strategy are in for a bit of a rocky road, however.

During the working years of the hypothetical individuals studied, each strategy produces large real drawdowns on average. The average maximal decline in value - the worst case loss experienced by an investor during a specific period - was 42% for U.S. Treasury bills, 67% for domestic stocks, 54% for the balanced strategy, 52% for the TDF, and 55% for the optimal strategy.

As the authors wrote, the optimal strategy's 55% average drawdown would cause discomfort for even the most stalwart investors, but each strategy that attempts to provide long-term appreciation is subject to similarly large average losses.

But investors, advisers, and regulators are likely most concerned about the largest potential drawdowns, the worst-case scenarios. And in their study, they found that the "optimal strategy" limits losses better than these other options in the worst-case scenarios, which makes it a more favorable choice for those who want to minimize the impact of catastrophic losses, she said.

"It's a matter of what you want to focus on," said Anarkulova. "Median, mean or the right tail."

Now we're not going to dive too deep into the study's methodology. In our more than 40-minute interview, Anarkulova referenced such things as age-based probabilities, simulated earnings, non-employment spells, the heterogeneity of the earnings path, constant relative risk aversion, survivorship bias, stationary block bootstrap, which is a sophisticated method for resampling time series data, independent and identically distributed $(IID)$ returns, price-dividend ratios, conditional analysis, the long-term correlation of bonds and stocks, purchasing power parity and so on.

Suffice to say the research seems solid and those who want to do a deeper dive into the methodology can read the initial draft of the study in this 70-page report, which we should note has been downloaded nearly 26,000 times from SSRN.com, making it the 212th most downloaded paper on that platform even though the paper was just placed there a little more than a year ago.

The experts' critique

What do others say about this approach?

Wade Pfau, author of "Retirement Planning Guidebook," agrees with the authors of Beyond the Status Quo that over a lifetime holding 100% in stocks generally offers a higher probability of achieving better financial outcomes.

"But this gets into the whole dynamic about the efficient frontier for retirement income consisting of stocks and annuities, instead of stocks and bonds," Pfau said. "Bonds really aren't useful. But people do have options about using annuities in place of bonds to take advantage of risk pooling in a manner that supports more spending in the same way that the risk premium from stocks can support more spending when realized."

Ultimately, from a practical perspective, Pfau thinks people without the risk tolerance to be 100% stocks will struggle to stay the course with what's prescribed in the paper, Beyond the Status Quo. "But having protected income sources - such as an annuity - to cover basic expenses may make it easier to use an aggressive stock allocation with the remaining investments," he said.

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December 30, 2024 12:30 ET (17:30 GMT)

MW 100% stocks for retirement? A new study says -2-

David Blanchett, the head of retirement research for PGIM DC Solutions, said he's written about some of the same concepts covered in the authors' paper, Beyond the Status Quo paper. Read Investment Horizon, Serial Correlation, And Better (Retirement) Portfolios.

"Returns aren't random over time and that equities become safer historically over longer time horizons and start to crowd out allocations to cash and fixed income," he said. "So, to the extent you could have stayed invested in equities for a really long time horizon, that would have resulted in more wealth historically, but we all know that today... this wasn't all so clear it would have happened 100+ years ago."

From Blanchett's perspective, "there's quite a bit of hindsight bias in (the Beyond the Status Quo paper) and the potential benefits of allocating to international equities today are a lot lower than they have been over the last 150 years." Correlations, he noted, have increased considerably over the historical period.

His bottom line recommendation around this research/concept? "There is definitely evidence that longer-term investors can/should take on more risk, but I wouldn't go near to the extent suggested in this piece of research - all equities dominate a more traditional life cycle approach," he said. "The key is can/will the person stay invested for the long-term?"

Anarkulova agrees that it's hard to predict whether what's happened in the past will continue in the future. "This is a statistical analysis," she said. "We are not forecasters or fortune (tellers). We are telling you what is true based on our setting and the data that we observe. Now it's up to you."

The advice for "real people" is still to invest in the optimal portfolio, however, she cautioned as did Pfau and Blanchett, "they have to be able to do it and hold it."

After all, Anarkulova noted, "it's still the case that more money is better than less money."

-Robert Powell

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December 30, 2024 12:30 ET (17:30 GMT)

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