Research Affiliates: What Are We Doing To Our Young Investors?

October 31, 2014

Starter Portfolio

What could be a possible remedy? Perhaps young workers should not invest in TDFs with high equity allocations at all until their starter portfolio reaches a certain minimum balance of, perhaps, six months’ income.4

What could this starter portfolio look like? The starter portfolio is the rainy day fund.5 It would be unwise to use the rainy day fund to go gambling in the casino in the hopes of doubling it at the roulette table. Similarly, compared with traditional TDFs, the starter portfolio should be less risky and less correlated with the young saver’s primary income. A portfolio invested one-third each in mainstream stocks, mainstream bonds, and diversifying inflation hedges would be a much safer option, compared to the conventional longer-dated6 TDFs where the average stock allocation is 70% or more.

What comprises that third sleeve of the portfolio, the diversifying inflation hedges? These would typically be lower volatility asset classes, lightly correlated to mainstream stocks and bonds, ideally with higher yield or higher growth or both, and with a positive link to inflation (to diversify against the negative link of mainstream stocks and bonds).7 This component might augment the classic balanced portfolio with investments such as TIPs, low volatility equity, and high yielding bonds. Even REITs and emerging market stocks and bonds might, in moderate doses, serve to lower the volatility of the overall portfolio.

By the time the balance meets the minimum amount, the savers would be familiar with the fact that the best investments involve some risk and will fall from time to time, and they will also be confident that they are reasonably well covered for a rainy day. The investors can start loading up allocations to more risky asset classes on the amount exceeding the starter portfolio minimum balance.

Conclusion
Current savings options blissfully ignore the fact the young use their 401(k) investments as their rainy day fund in case they have an unexpected and urgent need for cash. Often, this happens when they lose employment. Existing saving options force young savers to gamble aggressively with their early savings in the hope that they have enough time to recover from any unlucky market performance with more savings later in their lives. We can continue pretending that 401(k) portfolios are used only as intended—for retirement savings. Or we can face reality and offer our young investors a more prudent solution, one which would not force them to gamble with savings that they necessarily rely upon as a rainy day fund.

If young workers have to deal with their volatile young human capital over a long horizon—with a heightened need to cash out when the portfolio values are depressed—then it makes even more sense for younger workers to begin with a less risky portfolio. This also helps shape their risk tolerance so that their attitudes about investing and risk-bearing are not poisoned by a bad early experience. A prudent implementation would be to invest into a safer “starter portfolio” within their DC plan. Only when the relatively safe funds reach a comfortable level should investors consider taking more risk in the hope of generating excess return. And they should take that higher level of risk only on the portion of their portfolio that exceeds the starter portfolio’s minimum balance.

Endnotes

  1. See Gourinchas and Parker (2002).
  2. See Arnott (2012) and Arnott, Sherrerd, and Wu (2013).
  3. As of March 31, 2014, Morningstar reports that target-date mutual fund assets were $650 billion. See Treussard (2014).
  4. The father of one of the authors (Arnott) strongly advocated that no 40-year-old should fail to have a liquid reserve amounting to one year’s income. He liked to refer to this portfolio as his “go to h---“ fund, because it gave him the independent self-reliance to be able to say this if anyone thought that he was dependent on his biweekly paycheck. This was colorful language for a theologian, but most of us have heard others on Wall Street describe it in even more colorful language!
  5. Let us state most emphatically that young investors should never invade their 401(k) to make discretionary purchases. Borrowing against the 401(k) might strike inexperienced investors as an attractive source of funding for a highly coveted but inessential purchase. It is not. We have to help them understand this point.
  6. For savers with investing horizons of more than 25 years prior to retirement.
  7. We refer to these diversifying asset classes, with their positive correlation with inflation, as a “third pillar,” to complement classic two-pillar investing, especially in today’s low-yielding world. See, for example, West (2012, 2013) and Arnott (2011).

 

 

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