Most investors tend to become more conservative as they age. Advisors often recommend that investors move more of their retirement portfolio into “safer” bonds and cash investments and reduce their percentage of stocks the closer they get to retirement.
This is prevalent in life cycle or target date funds, which shift to more conservative allocations the closer one gets to retirement. For example, that might mean going from 70/30 or 80/20 stocks to bonds with a longer time horizon, to say 60/40 or 50/50 stocks to bonds at retirement age.
But a group of researchers say not only should investors keep their portfolios 100% in equities; they should also invest two-thirds of that in international stocks.
The paper, called “Beyond the Status Quo: A Critical Assessment of Lifecycle Investment Advice,” boldly challenges the tenets of lifecycle investing, saying life cycle or target-date fund investors need 61% more pre-retirement savings to match the all-equity strategy.
“An optimal lifetime allocation of 33% domestic stocks, 67% international stocks, 0% bonds, and 0% bills vastly outperforms age-based, stock-bond strategies in building wealth, supporting retirement consumption, preserving capital, and generating bequests,” the researchers said.
The paper, published on December 6, was authored by finance professors Aizhan Anarkulova at Emory University; Scott Cederburg at the University of Arizona; and Michael S. O’Doherty at the University of Missouri at Columbia.
All-equity strategy produces better long-term results
In their research, the experts examined the history of returns across asset classes from a broad cross section of developed economies. That includes returns for domestic stocks, international stocks, government bonds, and government bills from 39 developed countries.
Through this, they found the optimal fixed-weight portfolio strategy to be 33% domestic stocks, 67% international stocks, 0% bonds, and 0% bills. They then compared that to two different benchmarks — a balanced strategy with 60% domestic stocks and 40% bonds, and a representative target-date fund (TDF) that employs an age-based, stock-bond strategy.
“To achieve the same expected utility from retirement consumption and bequest as a couple investing in the optimal strategy and saving 10.0% of labor income, a couple using the balanced strategy must save 19.3% of income…nearly twice as much,” they wrote.
Further, a couple investing in the target-date fund must save 16.1%, or 61% more, to match the expected utility of the optimal fixed-weight strategy.
“The all-equity strategy dominates the QDIAs (qualified default investment alternatives) in long-term appreciation, with 50% more retirement wealth on average than the balanced strategy and 39% more than the TDF,” they wrote. “This additional wealth generates a larger stream of income for the retirees.”
Also, they found that households allocating 33% to domestic stocks and 67% to international stocks are less likely to exhaust their savings.
“Under the common 4% rule for retirement spending, a couple using the balanced strategy has a 16.9% probability of running out of wealth. The TDF is even worse at 19.7%. In comparison, the probability for the optimal, all-equity strategy is low at 7.0%,” the researchers said.
Diversify with international stocks
Investors may find the two-thirds allocation to international stocks even more surprising than the 100% all-equity optimal portfolio.
In fact, the researchers point out that including international stocks is “rare in the lifecycle investing literature.” But they underscore the importance of not just allowing for international diversification, but for giving it more weight.
In the optimal all-equity portfolio, international stocks essentially replace bonds, which they contend are unattractive for long-term investors. Bonds offer modest average real returns of 0.95% annually, according to their research, compared with international stocks at 7.03%.
“At short horizons, bonds appear less risky with lower standard deviation (9.51% versus 23.26%) and lower correlation with domestic stocks (0.21 versus 0.33),” they wrote. “At long horizons, the picture changes. Bonds’ per-period variance increases to 2.30 times the one-year variance, but international stocks’ decreases to 0.75 times.”
Also, the correlation of bonds with domestic stocks rises to 0.45 at 30 years, but the long-term correlation with domestic stocks remains steady for international stocks.
“Bonds ultimately seem unattractive for long-horizon investors,” the paper says. “They have low returns, high long-term variance, high long-term correlation with domestic stocks, and high exposure to inflationary periods.”
The authors don’t say that bonds are “inherently inappropriate for investors” or that diversification and age-based asset allocation is unimportant. But they do argue for the benefits of international stocks as a diversifier.
“The long-horizon return data suggest that diversifying with international stocks, rather than with bonds, improves investor outcomes for long-term appreciation and capital preservation,” they concluded.