If you’re saving for retirement, a broad-market index portfolio is usually a good choice. For example, investing in a target fund or S&P 500 index fund is a cost-effective way to gain broad market exposure. But newly published research suggests there may be a more lucrative way to invest your nest egg.
Analysis by Dimensional Fund Advisors suggests that retirement savers need to do more than just follow standard advice, such as using index funds, to achieve a balanced portfolio. DFA research shows that portfolios built with an emphasis on size, value and profitability premiums can generate more wealth and longer lifespans than broad-market portfolios. In fact, DFA researchers calculated that a portfolio weighted toward these premiums would leave a hypothetical 65-year-old investor with at least 20% more money, even if market returns lagged below historical averages.
“These results are encouraging. A portfolio that incorporates controlled, moderate premium exposure can strike a balance between higher expected returns than the market and the cost of slightly higher volatility and moderate tracking error,” DFA’s Mathieu Pellerin wrote in his paper “How Targeting the Size, Value, and Profitability Premiums Can Improve Retirement Outcomes.”
“As a result, targeting these long-term drivers of stock returns is likely to increase assets at the beginning of retirement.”
What are the size, value, and profitability premiums?
As part of its research, DFA compared the simulated performance of a broad market index portfolio represented by the Center for Research in Security Prices (CRSP) 1-10 Index with the performance of the Dimensional US Adjusted Market 1 Index.
The DFA Index contains 14% more stocks than the CRSP Index, placing more emphasis on the size, value, and profitability premiums. Here’s how the firm defines each of these:
- Size Premium: The tendency for small stocks to outperform large stocks.
- Value Premium: The tendency for undervalued stocks, i.e. stocks with low price-to-book ratios, to perform better.
- Profitability Premium: The tendency for companies with relatively high operating profits to perform better than companies with low profitability.
Thus, the DFA Index is biased toward small stocks, value stocks, and profitable companies.
Premiums produce better retirement outcomes
To test the long-term viability of fee-based portfolios, DFA ran a series of extensive simulations and compared the results to the CRSP market index.
First, Pellerin calculated hypothetical returns for each portfolio over a 40-year period, assuming an investor starts saving at age 25 and retires at age 65. Both portfolios are part of a glide path that starts with a 100% stock allocation and moves to bonds at age 45. By age 65, the investor’s asset allocation eventually reaches a 50/50 mix of stocks and bonds.
Next, he calculated how both portfolios would perform during the investor’s savings phase. To this end, DFA applied the 4% rule, a rule of thumb that says that a retiree with a balanced portfolio can withdraw 4% of their assets in the first year of retirement, adjust withdrawals for inflation in the years that follow, and have enough left over for 30 years.
DFA tested the portfolio against both historical returns (8.1% per year) and more conservative returns (5% per year).
Using historical returns, by the time our hypothetical investor reaches age 65, the premium-focused portfolio will be 22% more valuable than the overall market portfolio. Research shows that even in a low-growth environment, the DFA portfolio delivers 20% more intermediate wealth than comparable portfolios.
The hypothetical investor would also have a lesser likely to run out of money with a DFA portfolio. Using historical returns, the premium-focused portfolio would fail only 2.5% of the time over a 30-year retirement period, nearly half as often as the market portfolio’s return of 4.7%.
The range was even larger when Pellerin ran simulations with more conservative return expectations: Over a 30-year retirement period, with an average annual return of just 5%, the DFA portfolio ran out of money in just 12.9% of simulations, while the market portfolio failed 19.9% of the time.
Conclusion
Investing in index funds or target funds that reflect the broad market can be an effective way to save for retirement, but Dimensional Fund Advisors has found that targeting stocks with size, value and profitability premiums can lead to better retirement outcomes. When comparing broad market indexes to indexes that focus on these factors, the latter had at least 20% more median assets and lower default rates.
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