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It seems a lot of people recommend lifecycle funds. They're even an allowed default investment for 401ks now. But given how little I trust Wall Street, I'm curious if there's any quality academic research demonstrating that rebalancing towards a "glide path" is better than rebalancing to a static allocation.

Is there any research suggesting that "age-appropriate" portfolios means less stock and more fixed-income assets with age?

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I think not. I think a discussion of optimum mix is pretty independent of age. While a 20 year old may have 40 years till retirement, a 60 year old retiree has to plan for 30 years or more of spending. I'd bet that no two posters here would give the same optimum mix for a given age, why would anyone expect the Wall Street firms to come up with something better than your own gut suggests?

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    +1 for "no two posters here would give the same optimum mix" :) – Alex B Sep 2 '11 at 16:03
  • @Alex B - thanks. And thanks for vaulting me over lucky 13K reputation. – JoeTaxpayer Sep 2 '11 at 16:06
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The thing about the glide path is that the closer you're to the retirement age, the less risk you should be taking with your investments. All investments carry risk, but if you invest in a volatile stock market at the age of 20 and lose all your retirement money - it will not have the same effect on your retirement as if you'd invest in a volatile stock market at the age of 65 and then lose all your retirement money.

Static allocation throughout your life without changing the risk factor, will lead you to a very conservative investment path, which would mean you're not likely to lose your investments, but you're not likely to gain much either.

The point of the glide path is to allow you taking more risks early with more chances of higher gains, but to limit your risks down the road, also limiting your potential gains.

That is why it is always suggested to start your retirement funds early in your life, to make sure you have enough time to invest in potentially high return stocks (with high risk), but when you get close to your retirement age, it is advised to do exactly the opposite.

The date-targeted funds do that for you, but you can do it on your own as well.

As to the academic research - you don't need to go that far. Just look at the graphs to see that over long period investments in stocks give much better return than "conservative" bonds and treasuries (especially when averaging the investments, as it usually is with the retirement funds), but over a given short period, investments in stocks are much more likely to significantly lose in value.

  • "Just look at the graphs..." Well, young people aren't as wealthy. If you were to graph portfolio allocation between stocks and bonds over time, and measure the "stocks" and "bonds" areas as dollar-years, the bulk of that exposure is late in life. This observation is borrowed from a book of academic Robert Shiller, but I don't think it came with empirical analysis, just a hypothesis. I was really hoping to find a widely cited paper on the value of lifecycle investing.... – jldugger Sep 1 '11 at 22:14
  • @jidugger - but you're allocating your investments when you're making them, and then you know what your age is. It doesn't matter how wealthy you are, because you're dealing with proportions anyway. I fail to see the point in your comment. – littleadv Sep 1 '11 at 22:47
  • The point is that your wealth should grow with age, since you have make contributions over time. Proportionally, your younger self has hardly anything to be investing with. – jldugger Sep 2 '11 at 0:58
  • @jldugger - it is true that your wealth should grow with age, but it is not true that it has to grow lineary. Investments made when you're young have much more growth potential than the investments made when you're old. Why limit this potential? Proportionally, your younger self has hardly anything to be investing with. - yes, but the little contribution you've made at the age of 20 can become worth of 20 contributions you made at the age of 60 when you reach that age. If you lose it, however - you only lost one little contribution. – littleadv Sep 2 '11 at 7:29
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So I did some queries on Google Scholar, and the term of art academics seem to use is target date fund. I notice divided opinions among academics on the matter. W. Pfau gave a nice set of citations of papers with which he disagrees, so I'll start with them.

In 1969, Paul Sameulson published the paper Lifetime Portfolio Selection By Dynamic Stochaistic Programming, which found that there's no mathematical foundation for an age based risk tolerance. There seems to be a fundamental quibble relating to present value of future wages; if they are stable and uncorrelated with the market, one analysis suggests the optimal lifecycle investment should start at roughly 300 percent of your portfolio in stocks (via crazy borrowing). Other people point out that if your wages are correlated with stock returns, allocations to stock as low as 20 percent might be optimal.

So theory isn't helping much. Perhaps with the advent of computers we can find some kind of empirical data. Robert Shiller authored a study on lifecycle funds when they were proposed for personal Social Security accounts. Lifecycle strategies fare poorly in his historical simulation:

Moreover, with these life cycle portfolios, relatively little is contributed when the allocation to stocks is high, since earnings are relatively low in the younger years. Workers contribute only a little to stocks, and do not enjoy a strong effect of compounding, since the proceeds of the early investments are taken out of the stock market as time goes on.

Basu and Drew follow up on that assertion with a set of lifecycle strategies and their contrarian counterparts: whereas a the lifecycle plan starts high stock exposure and trails off near retirement, the contrarian ones will invest in bonds and cash early in life and move to stocks after a few years. They show that contrarian strategies have higher average returns, even at the low 25th percentile of returns. It's only at the bottom 5 or 10 percent where this is reversed.

One problem with these empirical studies is isolating the effect of the glide path from rebalancing. It could be that a simple fixed allocation works plenty fine, and that selling winners and doubling down on losers is the fundamental driver of returns. Schleef and Eisinger compare lifecycle strategy with a number of fixed asset allocation schemes in Monte Carlo simulations and conclude that a 70% equity, 30% long term corp bonds does as well as all of the lifecycle funds.

Finally, the earlier W Pfau paper offers a Monte Carlo simulation similar to Schleef and Eisinger, and runs final portfolio values through a utility function designed to calculate diminishing returns to more money. This seems like a good point, as the risk of your portfolio isn't all or nothing, but your first dollar is more valuable than your millionth. Pfau finds that for some risk-aversion coefficients, lifecycles offer greater utility than portfolios with fixed allocations.

And Pfau does note that applying their strategies to the historical record makes a strong recommendation for 100 percent stocks in all but 5 years from 1940-2011. So maybe the best retirement allocation is good old low cost S&P index funds!

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