If you’re saving for retirement, a broad market index portfolio is typically a good option. Investing in a target date fund or S&P 500 index fund, for instance, are low-cost ways to gain broad market exposure. However, newly published research indicates there may be a significantly more lucrative way to handle your nest egg.
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An analysis from Dimensional Fund Advisors suggests retirement savers can do better than following the standard advice to use index funds, for instance, to get a balanced portfolio. Portfolios built with a focus on size, value and profitability premiums can generate more assets and better longevity than broad market portfolios, according to the DFA research. In fact, a DFA researcher calculated that a portfolio that emphasizes these premiums would leave a hypothetical investor with at least 20% more money by age 65, even if market returns were less than the historical average.
“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.”
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“As a result, targeting these long-term drivers of stock returns is likely to increase assets at the beginning of retirement.”
What Are 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 – against that of the Dimensional US Adjusted Market 1 Index.
The DFA index comprises 14% fewer stocks than the CRSP index and places a greater emphasis on size, value and profitability premiums. Here’s how the firm defines each:
- Size premium: The tendency of small-cap stocks to outperform large-cap stocks
- Value premium: The tendency of undervalued stocks – those with low price-to-book-value ratios – to outperform
- Profitability premium: The tendency of companies with relatively high operating profits to outperform those with lower profitability
As a result, the DFA index is more heavily weighted in small-cap and value stocks, as well as companies with higher profits.
Premiums Produce Better Retirement Outcomes
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To test the long-term viability of its premium-based portfolio, DFA ran an extensive set of simulations and compared the results against the CRSP market index.
First, Pellerin calculated 40 years’ worth of hypothetical returns for each portfolio, 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% equity allocation and beings to transition toward bonds at age 45. By age 65, the investor’s asset allocation eventually reaches a 50/50 split between stocks and bonds.
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Then, he calculated how both portfolios would fare during the investor’s decumulation phase. To do this, DFA applied the 4% rule. This rule of thumb stipulates that a retiree with a balanced portfolio can withdraw 4% of their assets in their first year of retirement and adjust withdrawals in subsequent years for inflation, and have enough money for 30 years.
DFA tested the portfolios using both historical returns (8.1% per year) and more conservative returns (5% per year).
When applying the historical rate of return, the portfolio that targets premiums would be worth 22% more than the broad market portfolio by the time the hypothetical investor reaches age 65. In the lower growth environment, the DFA portfolios would still deliver 20% more median assets than its counterpart, according to the research.
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The hypothetical investor would also have a lesser chance of running out of money with the DFA portfolio. Using historical returns, the premium-focused portfolio failed just 2.5% of the time over a 30-year retirement. That’s nearly half as many times as the market portfolio, which posted a 4.7% failure rate.
That spread grew even larger when Pellerin ran the simulations with more conservative return expectations. Over the course of a 30-year retirement, the DFA portfolio ran out of money in just 12.9% of simulations when annual returns averaged just 5%, while the market portfolio failed 19.9% of the time.
Bottom Line
Investing in index funds or target date funds that track the broad market can be an effective way to save for retirement, but Dimensional Fund Advisors found that targeting stocks with size, value and profitability premiums can produce better retirement outcomes. When comparing a broad market index to one that focuses on these factors, the latter produced at least 20% more median assets and had lower failure rates.
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Retirement Planning Tips
How much will you have in savings by the time you retire? SmartAsset’s retirement calculator can help you estimate how much money you could expect to have by retirement age and how much you’ll potentially need to support your lifestyle.
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