94 – Two Funds for Life

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Episode Overview:

Ken continues his study of Paul Merriman and Richard Buck's financial insights. The duo, Ken explains, have begun developing a strategy that is simple for investors to implement. They found that proper asset allocation is key to success. To keep it simple, you allocate these funds to 1) A Target Date Fund and 2) A Small Company Value Stock Fund. Ken expands upon these funds and the simple math you can use to divvy up these funds. If your looking for simple, actionable steps, this episode is for you.

Transcriptions are auto-generated, please excuse grammar/spelling!

Happy day to you. This is Ken Kaufman. And I am thrilled you’re here for episode number 94, Two Funds for Life. Now, if you’ve paid attention to the last four episodes, I have been covering the book titled “We’re Talking Millions!: 12 Simple Ways to Supercharge Your Retirement,” written by Paul Merriman and Richard Buck. And in it, they go through these 12 ways. And I took…over the last four episodes, I went through the first three in the first episode, and then the next three, the next three, the next three, so that that covered the last four episodes. And hopefully, you’re able to gain some insights and some additional thoughts as you’re thinking about your investment portfolio.

Now Paul and Richard are now gonna step into an area where they’ve innovated. They came up with an idea that had not been really organized and presented in a way, and that was to really try to create a strategy that would be very simple for investors to implement. The strategy that I use is something that actually I got the ideas from a lot of the content that Paul Merriman’s done, but it’s complex. I have 13 to 15 total holdings in retirement or in my retirement funds, and rebalancing those and keeping track of those, it’s pretty complicated. Not to mention some of the money’s in a 401(k), and then there’s a traditional IRA and a Roth IRA and a self-employed 401(k) from self-employment income and all of those different types of things.

And so I want to be really clear here that this strategy that they’ve come up with and that they’ve, I think, done a great job developing is they’re trying to simplify it down and say…and I think they would love to say there’s just one fund, but I think you’ll find the argument compelling that two funds may be as simple as you want to be because one fund can be limiting. So they start out by talking about this concept of the target-date retirement fund. And, you know, those are very, very good options, but you’re missing out on some additional potential returns, and, again, this is all based on the past, no guarantee of any future results, but I think it’s really worthwhile to go through this.

And they start out by saying, “Hey, look, there’s no guarantee with results,” but what they found is is that if you get your asset allocation right then you’ve got a really high probability for investing success over time. And they feel like the easiest or the simplest way to implement all of the strategies they’re talking about is these two funds for life strategy where one of the funds is a target-date fund and the second one is a small-company value stock fund. And that’s it. That would be all you ever need.

And they say initially, “Hey, here’s one strategy you could go with.” If you put 90% of your money in your 401(k) into the target-date retirement fund, again, this is in your company retirement plan, and if you have all your future contributions go into that, and then 10% you have go into a small-company value fund. Hopefully, your 401(k) offers some type of an option around that, preferably not actively managed, but a passively managed index fund, that could be one way where… And what’s happening is the target-date retirement fund, it’s got some bonds in it even if you’re very, very young, and it invests in index funds that give you access to the total stock market, which are weighted toward large-company growth stocks and large-company even value stocks, and you don’t get a lot of exposure to small-cap.

And so the thought process here is by putting 10% into a small-cap value fund, it’s giving you some access to these extra potential returns. Now it does expose your portfolio to some more volatility, and they do some analysis around that that I’ll talk about here in a minute. So what they did is they said, “Hey, okay, so if you do 90% into the retirement-date fund or the target-date retirement fund, and you do 10% into the small-cap value fund,” they did an analysis in every 40-year period from 1970 to 2019. And what they found is that that strategy produced a higher return than if you just had the target-date fund alone, and the results vary depending on lots of different… You know, just because there are different time periods and things are going up and down as they do, the average improvement was 23% over that 40-year time period. That’s compelling to move just 10% into this second fund or in essence these 2 funds for life concept.

So if you wanted to get more aggressive and say, “Whoa, well, what if I did 20% or 30% or 40% into the small-cap value and then the rest went into the target-date fund?” Well, if you did that, in fact, here in the study they say if you did 20%, not 10%, in the small-cap value fund and the other 80% went into a traditional, you know, target-date retirement fund, the average improvement over a 40-year period was 45%, so that’s up from 23% with just 10% exposed to the small-cap value. So bumping from 10 to 20, you get some significant value out of that.

Now there is a downside to this strategy when you go static, meaning you have the same percentage in the target-date fund and then you keep the same percentage in the small-cap fund. And if you just keep those percentages, when you get older, you may not want to be exposed to that much risk as well as when you’re younger, you most likely could get away with exposing yourself to more of that risk because you’ve got time on your side as an investor.

And so this is where they went one step further with this two fund for life strategy, and it’s really at the core of the advice that they’re trying to give in this book

or the recommendations, they feel like the strategy is easy to implement, and it will be on a glide path, meaning exposing you to more risk in your earlier years. And then slowly moving you away from having a concentration in small-cap value and it going more and more to just the target-date retirement fund investments which tend to be less volatile, their ups and downs tend to be less.

And so this is what their strategy is. They basically say, “Look, if you multiply your age by 1.5, and then whatever that result is, that is what should be in your target-date fund and then the balance should be in the small-cap value or small-company value fund.” And then what happens is, as you get older, then you’re gonna be moving more conservatively, meaning less in the small-cap value fund and more into the target-date retirement fund. So let me give you an example, if you’re 30 years old, you multiply that by one and a half, and that gives you a number of 45. That means 45% of your portfolio goes into a target-date fund, the other 55% goes into a small-company value fund, simple enough, easy enough, right?

Well, when you get to 40 years old, now, if you multiply that by one and a half, that means 60% should be in the target-date fund. So over 10 years you move from 45% to 60% in the target-date fund, and then you move from 55% in the small-cap value fund to 40% in the small-cap value fund. And then when you’re 50, you’d go to 75% in the target-date fund and 25% in the small-cap value fund. This approach means you’re being more aggressive with your investments when you’re younger, and then it becomes, this is the words of Paul and Richard, it becomes gradually less adventurous as you get older.

So you might be wondering, “Well, how much does this strategy improve my overall outcome?” So, of course, true to form, Richard and Paul go through and back to 1970, and they wanted to see, “Hey, what happens over a 40-year holding period?” Now they do make a disclaimer here, target-date funds have not existed or didn’t exist until the 1990s. And so their research team built up a model that used a glide path and asset allocation similar to what Vanguard uses today for their target-date funds. And by trying to recreate into the past back to 1970 what that would look like, they made this assumption. They said, “Let’s say an investor starts with $1,000 in year 1 of each of the 40-year periods measured and then the investor adds another $1,000 each year for the next 39 years, so that means a total of $40,000 invested.”

And they did this based on this concept I talked about earlier, which is using the concept of dollar-cost averaging. And then when they went through and looked at all those returns, they came up with this result. With all that money going to the target-date fund, after 40 years, your average portfolio balance would be $698,000. So I’m just gonna call that $700,000 to make the math or to make the comparison here a little bit easier, and that’s just if you put everything in the target-date fund. If you then layered in this strategy of 1.5 times your age goes into the target-date fund and then the remaining goes into the small-cap value fund, this is what they came up with after…or the average of these 40-year periods came up with a portfolio value at the end of the 40 years at $970,000.

So that works out to about…I mean, sorry, I’m just gonna round a little here, about a $275,000 increase or about a 39% increase in return over those 40 years. That can be significant. And, of course, we know adding the small-cap, it’s gonna increase your risk, and so Paul and Richard had their team do the dig or do a deep dive on this and say, “Hey, what actually happens to risk?” And I’m gonna share some word for word here out of the book because I want you to understand how they think about risk. What they wanted to know was the worst ever drawdown in each case, and a drawdown is the percentage loss from a portfolio’s high to its subsequent low. So having the benefit of looking backward, they look and see, “Hey, a portfolio or, you know, an index fund or investment, it goes up, up, up, it hits a peak, and then it comes down, and how far down does it come before it starts to go back up?” And so they were looking for the biggest or most deep drawdown throughout the entire 40-year period or all of the 40-year periods that they measured.

And what they found was… And so let’s give an example. Let’s say the value of the portfolio peaked at $100,000, and then it bottomed out at $80,000. Well, then there’d be a 20% drawdown. Divide that into the $100,000. That’d mean it’d be a 20% drawdown. So the interesting thing here is that the drawdown was not that much different than by adding the small-cap stocks. So if you take a Vanguard-like target-date fund, just that, we know over the 40 years, putting $1,000 in a year, inflation-adjusted, it gets you this to a balance at the end of 40 years on average of all the 40-year periods measured $700,000, the worst drawdown. Meaning through those 40 years, they found the biggest change from a peak to the bottom of a valley, it was 41%. When you layer in the 2 fund for life strategy, it only went to 49%, so it’s only a variance of 8%, not a lot more risk or volatility added.

Now who wants to see their portfolio go down that low? Nobody does. The market goes up and down, and it can have very dramatic swings, especially when you look at something as wide as a 40-year period. But before you get too worried or concerned about that, remember over a 40-year period, you’re gonna have those ups and downs, but ultimately every 40-year period showed a positive up into the right. In fact, as you’ll recall, we started here in the 2 funds for life strategy, starting in the small-cap value and the target-date fund, when you combine those together in the strategy, the return took that $100,000 a year for 40 years, so total of $40,000, and turned it into $970,000 compared to $700,000 if you just did the target-date fund.

So that is hopefully a good explanation or a helpful explanation to you of this two fund for life strategy and how you can implement it easily. What you do is go and look in your employer’s 401(k) plan and find the target-date fund with the date closest to where you think you might retire, or if you want to even be a little more aggressive, go ahead and pick a fund 5 or 10 years, you know, further down the road in terms of its planning and run the math 1.5 times your age, put that amount into the target-date fund, and then find an index small-cap value or if there isn’t a small-cap value, look for a large-cap value-oriented index fund, and then that will…and then the balance goes into that. And then each year you’re going to make adjustments.

And my next episode, I’m gonna talk about rebalancing and how that all works and the mechanics of it. So just hang on a week, and I’ll get you that content so you know how to keep up and how to keep your portfolio in the right balance. But the key point here is is that from 1975 to 1999, the S&P 500 Index had a compounded return of 17%, and small-company value stocks were more than 22% during that period. From 2000 to 2019, the S&P 500 return was 6%, and small-company value stocks returned 10%. So small-cap value did better in both, but look at the big difference. We go from 22% to just a 10% return. Now the 10% return is still very good. Twenty-two percent would be considered very, very, very impressive, but you have to just remember that that variance, like, the fact that those returns can be so different, it’s really hard to bank on exactly how much money you’ll have in retirement, especially when you’re, you know, giving it the long-term view in what you’re trying to accomplish.

And so as you think about this strategy, as you think about it, the first thing I’d recommend is go and look at the funds being offered in your company 401(k) plan, or if you have rollover IRA, and you’re at an investment company like a Schwab or a Fidelity or an M1 Finance or a Vanguard, you can go and look and research all the funds and find an index, passively managed, small-cap value fund. And I can put in the show notes, Paul Merriman, they’ve got…on their site, they do an analysis of depending on what platform you’re on, what are some of the better options for small-cap value and other asset classes as well.

And so I’ll go ahead and put that in the show notes, but remember, as you think about this strategy and as you execute, you want to look at your whole portfolio, and you want to…every year you’re gonna be making an adjustment and doing a rebalance on your two funds. And it’s a really interesting strategy. I’m really glad actually that these two gentlemen did this research, that they’ve published it and made it available in their book, and they’ve talked about it now for a while and done some webinars, and they’ve published content around this concept. I think it’s a really interesting potential strategy. And when they talk about the 12 steps, they can’t do the part with save or spend less than you make and save the balance and you making the choice once you spend less than you make to actually take that money and save it and put it away, at least some of it, for the long term, but all of the other 12 areas of advice, the 2 funds for life strategy helps you solve.

And literally all you have to do is find the two funds, set up your 401(k) so the money goes in at the right percentages, and then once a year do a rebalance. And you’re headed toward a better outcome than the target-date fund most likely would be able to get you. And, again, this is just based on the research looking at the past, and over these 40-year periods, never saw a 40-year period where the target-date fund wasn’t helping to create the right outcomes, but you want to really seriously consider leaning into this strategy. And, like I said, I’ve gone several steps beyond this. I don’t have a target-date fund, but I own the index funds that are the underlying assets in like a Vanguard target-date fund.

But this is a nice step to help try to juice your returns and give you the best chance at a little bit more volatility, but give you the best chance to create the best outcome possible for your investments, especially over the long haul, especially the young investors need to be thinking about getting into small-cap value. You have time to handle the volatility and get some reward hopefully for the additional risk that you’re taking. I hope this has been helpful. Many, many thanks to you for joining today. This is a wrap for episode 94. Happy day.

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Join Chief Financial Officer Ken Kaufman as he helps you track and hack your net worth. For those seeking financial independence, your net worth is one of the most significant measurements of success. Using his two decades of financial experience, Ken Kaufman helps you overcome your financial obstacles and look onward towards a better, brighter financial future.

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