Investing for Retirement

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Arthur Dent
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Re: Investing for Retirement

Post by Arthur Dent »

Michael wrote:
Arthur Dent wrote: You should do a post on whether weighting up small caps makes sense.
For US equities? I don't think so. Although I prefer total stock market indexes (includes small cap), the performance differences between US total stock market and the S&P 500 index funds are almost identical.
Right, because the 500 biggest companies are such a large fraction of the U.S. market that the rest doesn't matter even if the index theoretically covers them. The thinking behind small cap exposure would be:
-Historically they've had higher returns
-These higher returns may make sense as a risk premium
-Similar to the logic behind selecting a higher equity to fixed income ratio when young, over the longest time horizons, it makes to sense to accept higher risk as a trade-off for higher mean expected returns.

But I don't know whether, in reality, this model is an accurate description of small caps in the current environment.
Michael wrote:It's worth noting, technically CAPE should be higher than other times because companies don't pay dividends like they used to.
I'm not sure I understand. Earnings should be earnings whether or not they are paid out as dividends. You can even pay a dividend when you're not currently making a profit. Seems to me dividends or no dividends, to first order, is only a tax concern and largely irrelevant in a tax sheltered retirement accounts. All returns should be computed as total returns with dividends included.

Actually that point always bothers me because comparisons very often show price return only. For example, your first figure seems to compare a total return international index to the price of the S&P 500, which isn't really valid. Even today when dividends aren't nearly the thing they once were, they are still a significant fraction of total investment returns.

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Re: Investing for Retirement

Post by Michael »

Arthur Dent wrote:
Michael wrote:
Arthur Dent wrote: You should do a post on whether weighting up small caps makes sense.
For US equities? I don't think so. Although I prefer total stock market indexes (includes small cap), the performance differences between US total stock market and the S&P 500 index funds are almost identical.
Right, because the 500 biggest companies are such a large fraction of the U.S. market that the rest doesn't matter even if the index theoretically covers them. The thinking behind small cap exposure would be:
-Historically they've had higher returns
-These higher returns may make sense as a risk premium
-Similar to the logic behind selecting a higher equity to fixed income ratio when young, over the longest time horizons, it makes to sense to accept higher risk as a trade-off for higher mean expected returns.

But I don't know whether, in reality, this model is an accurate description of small caps in the current environment.
I understand where you are going with this, but it feels overly speculative and complex to me. I prefer to keep things simple with broader diversification.
Arthur Dent wrote:
Michael wrote:It's worth noting, technically CAPE should be higher than other times because companies don't pay dividends like they used to.
I'm not sure I understand. Earnings should be earnings whether or not they are paid out as dividends. You can even pay a dividend when you're not currently making a profit. Seems to me dividends or no dividends, to first order, is only a tax concern and largely irrelevant in a tax sheltered retirement accounts. All returns should be computed as total returns with dividends included.

CAPE should be higher because instead of paying dividends companies are now hoarding cash or buying back stock. Both these things elevate P/E ratios as opposed to paying dividends. This isn't a bad thing. For most investors, dividends are taxed higher (ordinary income) vs selling stock (capital gains), so it makes sense. The white paper I linked highlights several CAPE criticisms (page 5).

Regardless, as the paper shows CAPE is pretty darn good. They also use some other convincing metrics.
Arthur Dent wrote:Actually that point always bothers me because comparisons very often show price return only. For example, your first figure seems to compare a total return international index to the price of the S&P 500, which isn't really valid. Even today when dividends aren't nearly the thing they once were, they are still a significant fraction of total investment returns.
You're referencing total return. This is a legit complaint, but in a marco sense, I doubt it changes things much. I don't have any metric to back that up, however.

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Re: Investing for Retirement

Post by Michael »

Swirls wrote: My particular plan's expense ratios have historically been higher for international equity funds than domestic funds, and their performance hasn't been high enough to offset the higher expense ratios. I typically rebalance and/or change funds a couple times a year, so perhaps I'll shuffle some lower performing domestic funds around with international ones.
I'm going to come back to this post. Earlier I discussed fees, but now I'm going to discuss my underlying philosophical investment point of view.

Before I dive in I want to say I'm going to make some assumptions about what you're doing. I'm inferring you're using actively managed funds, but that might not be true. Additionally, although I might disagree with your approach I'm not disrespecting you or anything. I'm just giving my point of view. Feel free to disagree.

So here we go:

If you're looking at past returns for actively managed funds you should basically assume they are meaningless. Typically the sample size is too small. If an actively managed fund has had good returns for the past 5-10 years I wouldn't read too much in to it. There are tons of funds out there and by chance some will have good returns over a longer time frame. Certain 401k plans will cycle them in and remove the dogs. That doesn't mean they are actually good funds. It just means some monkey was luckier at throwing darts at a stock board. I have no faith in active management once you account for their fees. Data backs up my assertion.

That's why I invest using the index based 3 fund portfolio. It's extremely diversified, simple and cheap. Check this out (spoilered for size)*:
[SHOW]
Image
Despite radical performance changes for asset classes from one year to the next I don't worry about it. I own almost all of it and my 3 fund portfolio beats most actively managed portfolios:
when Ferri and Benke evaluated a simple three fund portfolio made up of US stocks, international stocks, and US bonds, they found that the index-based portfolio outperformed the actively managed portfolio 82.9% of the time.

Not only that, but the professionals typically underperformed by 1.25% per year. And the small number of professionals who managed to outperform the market only did so by 0.52% per year.

In other words, not only were there far fewer winners than losers, but the losers lost by much more than the winners won by.
Also, the majesty of simplicity:
What they found was that the more complicated you made the portfolio, the more likely it was that the index-based strategy would win. For example, when they looked at a 10-fund portfolio that included a wide range of asset classes, the index-based portfolio produced better returns 89.9% of the time.
*I kinda dislike the AA portfolio they use in that pic.

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Swirls
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Re: Investing for Retirement

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At my current job, my 401k provider uses Vanguard (thankfully). Previously I was stuck with T. Rowe Price, Aon Hewitt, and Merrill Lynch - of those three, Merrill was the best but they still had pretty high fees overall and I didn't have a ton of funds to choose from. Here's how my current investment range is set up:

15% - Target Retirement 2050 Trust
5% - Vanguard Developed Markets Index Fund (Institutional Plus Shares)
15% - Vanguard Emerging Markets Stock Index Fund (Institutional Shares)
5% - Vanguard Inflation-Protected Securities Fund (Institutional Shares)
10% - Vanguard Institutional Index Fund (Institutional Plus Shares)
10% - Vanguard Mid-Cap Index Fund (Institutional Plus Shares)
10% - Vanguard PRIMECAP Fund (Admiral Shares)
10% - Vanguard Small-Cap Index Fund (Institutional Plus Shares)
10% - Vanguard Value Index Fund (Institutional Shares)
10% - Company Stock

Ideal mix for my age is basically 90/10 stocks/bonds, but right now I'm around 93/7. Will probably shift my company stock to something else later this year when I rebalance/reallocate. Probably either to the target retirement or the emerging markets fund.

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Re: Investing for Retirement

Post by Michael »

Very cool that you have Vanguard! Other than the company stock, why not just put everything in the 2050 fund? That's what I would do.

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Swirls
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Re: Investing for Retirement

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Mostly because for the past year or two, the other funds have pretty much been doing as well as or better than the 2050 fund with similarly tiny expense ratios. More diversification I guess in case one of the funds tanks. Even though I know that's essentially the point of having mutual funds where you have 50 different stocks or something that form the fund itself - I guess it gives me double diversification?

In the past at my other jobs I had everything in the target retirement funds or company stock - we really didn't have many options to choose from. This is the first time I think that I've had something ridiculous like 30-40 funds available to pick from beyond company stock or target retirement funds.

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Re: Investing for Retirement

Post by Michael »

Right now I suspect you're getting a lot of stock overlap with your asset mix, which lowers diversification. The 2050 is max diversification without the overlap. The 2050 owns everything in those funds expect the Inflation-Protected Securities, but it does own bonds, which I think at your age (early 30s?) makes more sense.

Plus the 2050 is super easy. If my 401k offered that fund I'd transfer everything in to that in a heartbeat.

YMMV. Michael is not a licensed financial adviser, etc

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Re: Investing for Retirement

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Michael wrote:Right now I suspect you're getting a lot of stock overlap with your asset mix, which lowers diversification. The 2050 is max diversification without the overlap. The 2050 owns everything in those funds expect the Inflation-Protected Securities, but it does own bonds, which I think at your age (early 30s?) makes more sense.

Plus the 2050 is super easy. If my 401k offered that fund I'd transfer everything in to that in a heartbeat.

YMMV. Michael is not a licensed financial adviser, etc
Hmm, I hadn't thought about the overlap, but the logic definitely makes sense. That's definitely something I will consider when I get ready to rebalance.

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Re: Investing for Retirement

Post by Michael »

Home ownership is overrated:
Owning a home may help you save money, but it won't help you make money.

Households are better off taking control of their finances than relying on fluctuating home values. That is the finding of a new study conducted by Florida Atlantic University, Florida International University and the University of Wyoming.

"On average, renting and reinvesting wins in terms of wealth creation regardless of property appreciation, because property appreciation is highly correlated with gains in the traditional financial asset classes of stocks and bonds," wrote study co-author Ken Johnson of FAU's College of Business, in a release.
Still, researchers in the study claim the old adage of "throwing your money away on rent," doesn't hold up. That is because it assumes that the extra money a renter saves by not owning a home and not saving for a downpayment is simply spent on goods or services and not invested.

"When you assume that those monies are reinvested at a rate of return, renting, on average, wins in terms of wealth creation," Johnson said. "Of course, many renters will not reinvest those monies and will instead use them for consumer goods, which is the least desirable option in terms of building wealth."
Link


Not surprised by this article. Recently, I've come to this conclusion home ownership is one of the most overrated things an adult can "accomplish". If I ever move from my current place I'll be looking to rent.

Arthur Dent
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Re: Investing for Retirement

Post by Arthur Dent »

Michael wrote:Home ownership is overrated
Agreed that this is mostly true financially.

A couple of things worth mentioning, though:

-They seem to be comparing house price appreciation against stock returns 1:1, but housing investment is typically highly leveraged. This multiplies return (by increasing the risk). Using margin for a long-term housing investment is viable whereas it is not for stocks.

-I'm not sure of the fraction, but for a large number of people the, "it helps you save" argument turns out to be massively important.

-Just looking at cash flow rather than total returns, owning can reduce financial risk compared to renting because you lock in much of this variable. When renting, you are at constant risk of being priced out. Of course, the flip side of this is the total return risk to owners in the case of a price crash, especially given that such events are not unlikely to be timed to when you need to sell and move.

But, bottom line, yeah, it is very overrated in investment terms. Being disciplined to save one way or another is more important, and you should buy a home if you'd like to own a home, not because it's a ticket to great financial outcomes.

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