In The Truth About Retirement Planning: Part 1 I shared tips that showed you the easiest and quickest ways to a financially worry-free retirement.
In this article, I expand on some nuances to help guide you to a more stable path on your way to a secure retirement.t.
Asset Allocation: Why it Matters
I already covered why diversification is so important in your retirement investments. First, let’s start with a couple of definitions that will be helpful to those of you who are new to the terms, asset classes and asset allocation.
Asset Classes are investments that share the same market characteristics; such as bonds, commodities or stocks. These asset classes can be further divided into smaller asset classes, such as treasury bonds, corporate bonds, small-cap stocks, large-cap stocks, gold, and silver.
Asset Allocation is the process of deciding what percentage of your investment portfolio money will be invested in each asset class that you choose to invest in.
Several studies including Ibbotson and Kaplan (2000), and Brinson, Singer, and Beebower (1991) show that your asset allocation decisions are critical. Using data from pension and mutual funds, the studies showed that about 90% of a fund’s returns over time could be explained by its target asset allocation policy. Remember this 90%.
Let’s look at the impact of the effects of asset allocation in a comparable real-life situation. Target date funds are becoming increasingly popular with investors because they take care of your investment decisions based on one’s estimated retirement date. I took a look at the top-performing and bottom-performing target funds over the last five years, and what I found might surprise you.
The difference in returns wasn’t due to one portfolio manager being better than the other. It was all due to asset allocation and how much risk they were taking. That has enormous implications for your choice on where to put your retirement money, should you decide to use target funds.
The top-performing target funds outperformed the lowest by about 4-5% a year on average across various target dates for the past five years. The best performing funds underperformed the worst performing funds in 2008 by 8-9%.
The difference can be explained by asset allocation. The funds that performed the best over the last five years simply had more exposure to the stock market than the worst performing funds. The funds that performed the best during the stock market correction of 2008 had a lower stock exposure. Before you pick a target fund, make sure you look at their asset allocation to understand how much risk you are taking on.
Let’s take a look at 2025 target date funds. The top performer over the last five years had an equity exposure of 74%. The worst performer had an equity exposure of 62%. That one line item explained most of the difference in performance. Remember, about 90% of a fund’s returns over time can be explained by its target asset allocation policy.
If we have another market correction, the lower performing funds with a lower risk profile will again provide better performance. If we end up with deflation, the less risky portfolio will also do better.
The challenge of asset allocation is that over time, asset classes (stocks, bonds, domestic, international, large cap, small cap, growth, value) produce different results, and no one knows for sure which asset class will produce the best returns going forward.
Although many attempt the feat of successful prediction, no one yet has succeeded with much consistency. There are just too many factors to take into account, most notably black swan events, which are unexpected and impossible to predict ahead of time with any degree of accuracy.
Measuring Your Funds/Financial Advisors Performance
To know how your investments or your financial advisor are performing, you have to compare them to a benchmark. A benchmark is a comparison standard. The benchmark should mimic the asset allocation being compared as closely as possible. For example, an active stock mutual fund would be compared to the S&P 500. A small cap stock mutual fund would be compared to the small-cap stock sector. You do the best you can to compare like to like.
The benchmarks I use for my model portfolios are the appropriate target date funds offered by various investment companies. It’s essential to compare my strategy to those funds that have a similar allocation strategy between stocks and bonds.
Remember that 90% of a fund’s returns over time can be explained by its target asset allocation policy. I had shown previously that this one simple observation explained the difference in returns between the top performing target date funds over the last five years compared to the lowest performers.
The biggest question that comes up at this point is: why manage your retirement funds if you can use a target fund? First, using a target fund is a great option and still saves you money compared to using a financial advisor. The advantages of doing it yourself include saving money on fees, having control over where your investments are placed (you can use funds from any company to mix and match), and being able to use portfolio rebalancing to improve your performance and lower risk.
When you manage your funds, the real power comes when you take advantage of market corrections or invest in sectors that traditional target funds may not use.
Financial Advisor Alternatives
If you don’t have complex estate planning, there are some alternatives to paying extra fees for a financial advisor.
If you’re going through your employer one of the easiest ways to manage your retirement funds while reducing costs while maintaining performance is to use Target Date Funds. Target date funds provide you with a professional money manager and diversified investments for a lower overall cost. The best option is a Target Date Fund that’s built using Index Funds (lower fees). Be careful though, not all Target Retirement Funds are the same.
Robo-Advisors are a second option that is gaining in popularity. While it’s a step in the right direction, you have to be very careful as you don’t have control over your investments and it can be hard to verify their financial stability. The investment process itself is automated, and automated trading has been blamed for stock market flash crashes. The risks can be substantially higher if the firm exposes you to illiquid ETF’s. Also, if they don’t offer model portfolios that can be tracked, it can be hard to verify their results and track record. There are now services that monitor the disparities in Robo-Advisors returns. I highly suggest you track
The third option is to manage your account yourself and use the best available Index Funds. That’s what we use in our market-beating model portfolios in the Value Investors Associations Retirement Investing Journal.
TIP: Your financial advisor will probably tell you that you can’t measure their performance because it’s tailored to the individual. While that is partly true, you can compare the returns they are providing you AFTER fees by comparing to a Target Date Fund.
Staying on Track – Rebalancing Your Retirement Investments
Pay attention to the tip at the end of the staying on track, re-balancing your portfolio section. This simple tip alone will save you a lot of money by reducing your fees and taxes.
Asset allocation is the primary determinant of a portfolio’s risk and return characteristics, assuming you have a well-diversified portfolio and use limited market timing. Therein lies the reason why portfolio re-balancing is so essential. It keeps you as close to your proper asset allocation as possible, which will maximize returns for the given amount of risk that you’re willing to accept.
Re-balancing doesn’t avoid losses or always maximize absolute returns, but it does minimize risks. It forces you to apply the fundamental value investing premise of buying low and selling high, which is why it works so well.
Consider this. Over the last three years, only one ETF fund made it in the top 10 list for performance for all three years. Unless you knew ahead of time which fund that one out of 10 was going to be, you were better off rebalancing to lock in gains on the biggest winners, and buying into the others at lower prices before they made their move up.
Markets move in cycles, and no one has been able to predict with any accuracy when they will start and when they will end. It usually takes people by surprise. Just think back to 2007 and 2008, when just about all the market pundits were saying that stocks weren’t overvalued, and how great the following year would be, right before the financial crisis. How about 2009, when everyone was afraid of the market, right before it went on a tear for some spectacular-sized gains. History is littered with economic predictions that went bad.
The other advantage of periodically rebalancing your investments is that it forces you to do the right thing when human behavior is telling you to do the exact opposite. It forces you to sell at high prices and buy at low prices.
In the research I conducted, there was no meaningful difference in the risk-adjusted returns using monthly, quarterly, or annual rebalancing periods. However, the number of re-balancing periods did increase costs, which negatively affected returns. In addition, there was the hidden cost of the extra time it took to re-balance on a more frequent basis. Due to time and cost considerations, re-balancing every year or even every other year is likely to produce the best returns.
The other option is to re-balance once an asset class (large stocks, bonds) has deviated more than 10% from your original allocation percentage. For example, let’s say your model portfolio is fairly simple with 50% of your investments in stocks and 50% in bonds. If your percentage of assets in stocks rose to 60%, you would sell enough of your stock funds to get it back down to 50% of your overall portfolio and put the gains into bonds to get it back to the 50/50 ratio. That said, annual or even bi-annual (every other year) rebalancing is the preferred method when tax considerations or substantial time/costs are involved.
While balancing more frequently or using the 10% threshold may produce better returns, transaction costs and taxes would negate the difference, and in most cases produce lower returns. Always consult with your tax accountant when re-balancing taxable accounts to make sure you are making the best decision.
TIP: An easier way to maintain the correct percentages while reducing transaction costs is to direct new investment dollars, dividends, and other cash flows into the most underweight asset class(es) to maintain the proper asset allocation.
Next, in The Truth About Retirement Planning: Part 3 I cover how much money you will need to save for retirement (the answer will likely surprise you), a simple plan to get you there and the best free resources to help you out.