Experts differ on which is the best approach to investing throughout your life. Some say to maintain a fixed percentage allocation in stocks, bonds, and cash regardless of your age. Others advise a lifecycle approach where you invest heavily in stocks while you’re young and shift to bonds and cash as you get older.
Larry MacDonald reported on a recent study by researchers Basu, Byrne, and Drew titled Dynamic Lifecycle Strategies for Target Date Retirement Funds (full text of the study is available free). The title hints at a market-timing strategy which piqued my interest.
The study compares fixed allocation strategies, lifecycle approaches, and a dynamic strategy the researchers devised. It turns out that the dynamic strategy doesn’t really involve market timing in the sense of trying to anticipate bull and bear markets. The dynamic strategy begins with a target yearly compound return expectation of 10% and makes the following choice each year:
- If your compound average lifetime return so far is less than 10%, then invest 100% in stocks.
- If your lifetime return exceeds 10% per year, then use the allocation dictated by a lifecycle strategy (more stocks if young and less if old).
So, this dynamic strategy has a built-in sense of how much the investor needs at retirement. The strategy gets conservative when returns are on track, and goes for broke with all money in stocks when lifetime returns are under par.
One finding from the study is that this dynamic strategy tends to beat the lifecycle strategy. This is hardly surprising because, on average, the dynamic strategy will have more money invested in stocks over the years, and we know that stocks tend to beat bonds and cash over the long run.
One aspect of the dynamic strategy that concerns me is that if the portfolio gets behind on its target return, it stays 100% in stocks right into retirement. This tendency to go for broke assumes that if you miss your target retirement dollar figure, it doesn’t matter how much you miss it by. However, if you were hoping for $2 million, you’re still better off with $1.5 million than just $1 million.
Apart from this problem with the dynamic strategy, there is a lot to like here. For investors who are behind in the amount they have saved, it makes sense to invest more in stocks to catch up. For those whose savings are well on track to give them as much as they need, it makes sense to get more conservative, sacrificing excess returns for greater safety.
In the never-ending search for the best investment approach, I suspect that including some amount of this dynamic strategy is better than just sticking with a pure fixed allocation or a pure lifecycle strategy.