Personal Wealth Management / Financial Planning

Shaped for U?

In our view, the so-called u-shaped investment strategy is fraught with peril for investors.

How are U investing for retirement? An age-based allocation? Goals-based? Target date funds? Random selection of securities with no overarching theme? We’ve seen them all. Now a recent study suggests another option: The U-shaped asset allocation model. U-shaped asset allocation is not investing text speak. The “U” in U-shaped is the percentage of your portfolio invested in stocks. The idea is to dial down equity exposure and increase bond exposure in the years immediately preceding retirement, with the trough reached when you first retire and for a few years following. Maybe that doesn’t sound so newfangled. The twist is later in life the U-shaped model has you ratcheting equity exposure back up. Sound bizarre? While there is some logic to this model, overall the strategy is based on a huge misperception, and U-sers likely find more problems than solutions.

To the strategy’s proponents, the logic behind slashing equity exposure during retirement’s early years is that’s when investors are hurt most by participating in a bear market. In their view, since withdrawals to fund retirement would be drawn off a lower base in a bear, depletion risks rises. Only years later, with their nest egg supposedly more secure, should folks invest more heavily in equities—get more growth to support cash flows later in life.

To be fair, U-shapers get a couple things right: Asset allocation—the proportion of stocks, bonds, cash and other securities—matters. Numerous studies show it drives up to 90% of long-term returns. In addition, the U-shapers correctly see longevity as a risk factor. However, though it correctly identifies asset allocation’s importance, U-path theory gets the decision exactly wrong and, by doing so, can unwittingly increase the risk you outlive your money in the name of trying to reduce it.

It’s true that greater equity exposure makes your portfolio more susceptible to short-term volatility or the risk of a bear market. And if you’re taking fixed dollar amount cash flows, the risk of depleting your portfolio will rise if overall portfolio values fall. (At least, it will for a while.) But there is inherent timing built into the U-shaped strategy. The strategy mixes and matches asset allocation and tactical portfolio positioning.

If a bear does come after you dial back equity exposure, then no big deal, you’re ready! But what if it doesn’t? Or what if the bear market comes before your retirement, while you have more exposure to equities and you’re dialing back after suffering the losses? If that’s the case, you’ve already taken the hit and locked in losses at the trough of your U. What if your retirement date was in 2009? If you adhered to the strategy, increasing bond exposure in the few years leading up to retirement might have mitigated your losses in the 2007-09 bear market. But you’d also be heavily invested in bonds for the first few years of the bull market, and now you’re likely lagging the market significantly. Worse, if the timing is even more wrong, you could have suffered the bear, reducing equity exposure before markets have recovered materially. Further, people retire every year, so subscribing to the U-shaped school of thought assumes a bear market could happen every year. And one could! But that’s possibility, not probability. In probability land, making a bet a bear will come is wrong two-thirds of the time. Historically, stocks have risen in more than 70% of rolling 12-month periods since 1926. Rolling five-year returns have been positive 86.9% of the time.i And none of this says anything about the returns of what you buy. Bonds can be negative, too.

If a bear market doesn’t happen and you’ve dialed back your equity allocation greatly, you’ve not only rebalanced for no reason, you’ve lost. Opportunity. While that might not give you vomitility the way volatility does, it is arguably a more significant detraction from your long-run financial picture.

In our view, shifting an allocation unnecessarily increases the likelihood you miss out on high, equity-like returns—integral to long-term portfolio performance. The principal reason to invest in stocks long-term is compound growth—a return on your return. At the outset of retirement, the time you need your money to last is at its longest—which is what U-shapers see. But it is also the point in retirement when you have the longest for your money to compound. Returns earned in these early years have the most time to earn returns on returns on returns on ... you get the picture. Giving this up chucks the time value of money out the window. Shifting away from equities early can greatly decrease the amount of money you have throughout retirement, and you could miss your long-term goals by reducing the power of compound growth.

In our view, investors’ strategies should be long-term—designed to target your financial goals and objectives over your entire time horizon. (And while tactical positioning is valid, this has to be focused on forward-looking market conditions.) These factors—not the date you hit the beach with a piña colada in hand—should determine your long-term asset allocation, and it should only change if your financial situation does materially. If stocks are appropriate for your long-term goals, they darn well better be appropriate when your goals are the furthest away. Simple as that. No weird, letter-shaped paths necessary.

i Source: Global Financial Data, Inc., as of 07/26/2013. Stocks are represented by the S&P 500 Index from 12/31/1925 – 06/30/2013.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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