Archives for October 2010

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Target Date Fund Risks

I like target date funds, a.k.a. target retirement funds. (More precisely, I like Vanguard’s target date funds. Every other fund company charges too much. In fact, according to Morningstar, the next-cheapest provider charges more than three-times what Vanguard does.)

With just one fund, you get all of the following:

  • Diversification across the three most important asset classes: domestic stocks, international stocks, and bonds.
  • Extremely broad diversification within each of those asset classes, and
  • Automatic rebalancing, so you don’t have to worry about it.

Not bad!

But target date funds have their flaws too. And this last week was a perfect example.

The Risk of Target Date Funds

Vanguard recently announced that they’ll be increasing the international allocation of their target retirement funds from 20% of the stock portion of the portfolio to 30%.

This isn’t a huge change. And I’m inclined to say it isn’t a bad change either. (In fact, it puts the portfolios closer to what I’d usually recommend.)

But it is a change. And unless you’re paying attention, you wouldn’t know about it.

And therein lies the danger: The entire point of target date funds is that they’re for investors who don’t want to pay attention to their portfolios.  They want a hands-off, automated solution.

Doing Your Homework

Before investing in a target-date fund, it’s absolutely essential to check its current asset allocation as well as its glide path (that is, the way in which the fund will shift its allocation in the future).

But that’s not enough. The glide path described in the prospectus is not a contract. The prospectus may tell you that, ten years from now, the fund will have X% of the portfolio in bonds, but that’s not necessarily true. Any time between now and then, the portfolio manager could change his/her mind.

In short, target date funds are actively managed mutual funds (even though they may be super-low-cost and composed of index funds). There’s somebody at the helm making decisions about what allocation the fund has.

The takeaway: Target date funds are a low-maintenance approach to investing, but they’re not a no-maintenance approach. Be sure to read any communications you receive from your fund company, and be sure to check your fund’s allocation on a regular basis to minimize surprises.

Planning Your Retirement Spending

This article may sound a bit “out there” at first. But stick with me. I think it has some interesting ramifications for retirement planning.

Imagine this (clearly hypothetical) scenario:

  • You’re 65 and recently retired.
  • You have an inflation-adjusted pension that, together with Social Security, will meet your most basic spending needs.
  • You also have $250,000 saved.
  • The only way you can invest this money is in a savings account with a return that precisely matches inflation each month.

In other words, we’re eliminating two of the biggest uncertainties that go into retirement planning — inflation and market returns — and leaving only one: longevity risk. You don’t know how long you’re going to live.

In light of that fact, how much would you spend each year?

Possible Retirement Spending Approaches

One obvious approach would be to look up your remaining life expectancy and plan to spread your $250,000 evenly over that period.

Or, you might plan to spread your spending evenly over a longer-than-average life span in case you’re lucky enough to live longer than average. (Though if you do that, how much longer than an average life span would you plan for?)

Probability-Weighting Your Budgeting

In the book Pensionize Your Nest Egg by Moshe Milevsky and Alexandra Macqueen, the authors argue in favor of a third strategy: Plan to spend more in the early years because there’s a higher probability that you’ll be alive to enjoy them. (That is, it’s less likely that you’ll be alive at age 100 than at age 67, so it makes sense to budget less inflation-adjusted spending for age 100.)

Fascinating idea.

I think I agree that it makes sense to give more weight to happiness in years you’re more likely to experience than to happiness in years you’re less likely to experience.

Marginal Utility of Money

On the other hand, there’s also something to be said about the decreasing marginal utility of spending. (That is, the second $10,000 spent in a given year typically provides less happiness than the first $10,000. And the third $10,000 provides even less.)

The interesting thing about marginal utility of money is that it’s different for every person.

For example, for me, the second $10,000 of discretionary spending each year may provide far less happiness than the first $10,000. In that case, when planning how to spend my $250,000, it would make sense to plan for only $10,000 of spending in each of the early years, rather than giving them a higher spending level as a result of the fact that they’re the years I’m most likely to experience.

In contrast, if the happiness that you get from the second $10,000 of discretionary spending each year is only slightly lower than from the first $10,000, it may make sense for you to budget for a higher spending level in the early years of retirement, so as to take advantage of the fact that you’re more likely to live to see them.

What Does This Have to Do with Real Life?

If you temporarily ignore market risk, inflation risk, and every risk other than longevity risk, you can see what sort of spending path you are shooting for. Then, you can create investment and spending plans that increase the likelihood that reality conforms as closely to that goal as possible.

For example, if you know that your happiness is hugely dependent on having a certain level of income every year, no matter how long you live, it probably makes sense to purchase a fixed annuity to ensure that level of income.

Alternatively, if you’re flexible with your spending and don’t mind living very frugally when you have to, you can probably afford to take more risk in your portfolio and/or use a more aggressive spending rate in your early years.

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Are You A Long Tail Investor?

This is a guest post by The Digerati Life, a general personal finance blog covering topics such as 0% purchase credit cards and top credit card deals.

Long tail investing means looking outside the norm regarding potential investments.

For example, if traditional investing means opening an account with a cheap online broker and putting your money into stocks, bonds, mutual funds, and ETFs, long tail investing might be any of the following:

Get into a new kind of trading: No, I’m not talking about day trading stocks. I’m talking about building a simple trading business that involves buying goods in another country and selling it in America. For instance, you can buy goods from China and find a way to distribute them in local stores.

Investing in foreclosures: With the real estate investment climate still in the doldrums, foreclosures are common. If you take your time to shop around, researching numerous different properties, you may find one with the potential for very high returns.

Buying websites: Would you consider buying virtual real estate on the web and turning it around for a profit? It may not take much to monetize such websites to help them increase their value.

[Mike’s note: If I had more free time, I’d be buying defunct blogs left and right. After they quit blogging, many writers let their sites sit there (making no money), despite the fact that they continue to get traffic from search engines.]

As you can see, long tail investing is often a combination of investing and entrepreneurship.

Is Long Tail Investing High Risk?

You may think that long tail investing is riskier than traditional investing. That’s not necessarily the case. Yes, such investments can be high risk, but I’m not at all sure they’re riskier than, say, a small-cap value mutual fund — something which in many circumstances is considered to be a prudent investment.

Long tail investments have two unique risk-mitigating factors.

First, when searching for long tail investments, you have the opportunity to narrow the field to niches with which you’re intimately familiar. With large, publicly-traded companies, there’s no way to have this intimate level of knowledge unless you work for the company — in which case it becomes a terrible idea to put much of your money there.

Second, after making the initial investment, you play a direct role in the outcome via your resourcefulness and work ethic. This is quite different from stocks or mutual funds where you have no control over what returns are earned.

Finding Long Tail Opportunities

The trick is to look for niche strategies, because that’s where the undiscovered opportunities will lie. Do not simply go for the first potential investments you come across.

With this type of investing, you may stumble upon a niche that may become more widely known as time goes on. If you explore the options now, you can potentially get a good return on your investments before many other people realize what is happening.

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