New Research Questions Conventional Investing Strategy

Chuck Williams

By: Chuck Williams - Dean, Butler University College of Business

Categories: Financial, Investment

Considering the recent turmoil in the stock market, you might be surprised if I suggested you should be 100 percent invested in stocks until 10 years before retirement. After all, conventional wisdom holds that you need a diversified portfolio of stocks and bonds for investing success.

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But new research by several professors from Butler University’s College of Business suggests that conventional wisdom may be wrong. Based on both historical results and a simulation of thousands of possible outcomes, they found that a much greater emphasis on stocks throughout most of your investing career will provide a much larger retirement portfolio than previously expected.

To understand what a startling change this is, let’s look at the usual investing strategy recommended by financial planners. They suggest that when you’re young, you should start off with a higher proportion of stocks and a lower proportion of “safer” investments such as bonds. As you age, the percentage of equities in your portfolio would decrease and the percentage of bonds would increase.

Many planners use age-based formulas to determine the appropriate percentage of stocks in your portfolio. A typical formula is 100 minus your age to determine these percentages. If you are 30 years old, for example, 100 minus 30 suggests that 70 percent of your portfolio should be stocks. Some “life cycle” mutual fund programs will automatically change these allocation percentages for you as you age.

About a year ago the Butler professors began a project that uses historic data to analyze the volatility of the stock market and the average rate of returns over time. The research discovered:

For every possible 40-year period, an investor who was invested 100 percent in stocks until 10 years before retirement and then switched to bonds would enjoy better returns than someone who followed conventional wisdom. Let’s call it the 100/10 Approach.

The reason is the investor’s patience with the stock market. While the market may be volatile over a 40-year period, the research shows that increases and decreases in stock value eventually level out on the up side under the 100/10 Approach.

By contrast, an impatient investor might pull out of the market when his or her stock was at a low point — getting only the downside and missing any chance of recovery. The volatility would not level out because he or she would come out of the market at the wrong point.

So why don’t financial planners advocate the 100/10 Approach? I suspect to avoid liability. For example, if you were 100 percent invested in equities last year when the markets were down over 30 percent, you’d be hurting. By advocating an investment mix with bond exposure, mutual funds providers avoid such a nightmarish scenario … and potential lawsuits.

Our research suggests that you shouldn’t be too conservative when investing in the stock market. However, your ability to adopt the 100/10 Approach likely depends on whether you become emotional about trading.

What should an investor do? First, learn and understand how volatile the stock market can be. Armed with that information, decide if:
• You’re an investor who can stick it out and ride through the highs and lows in the market. If so, you might consider the 100/10 Approach to maximize your returns.
• You get nervous if the stock value begins to inch downward. If so, you might be better off forgetting the 100/10 Approach and instead depositing your money in a life-cycle fund, where someone else can manage it.

Some rules of investing haven’t changed. The earlier you start investing, the more wealth you’ll accumulate because of the power of compounding. If you began putting away $100 per month when you were 20 and continued to do so for the next 40 years, you would wind up a millionaire by age 60, provided you had invested in a portfolio of average stocks. And wouldn’t that be fun to brag about?

Steven Dolvin, associate professor of finance for Butler University’s College of Business, contributed to this article.

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