Easy Formulas Prove Costly for Investors

Target-date funds' increasing allocation to bonds as investors approach retirement has backfired this year.

By Randall Watsek

It is natural for busy people to rely on “rules of thumb” to make decisions easier when they have a lot going on in their lives. What is less understandable is when an industry of professionals promotes products based on reducing the complexities of life to an arbitrary formula. There is no substitute for putting thought into everyone’s unique situation.

One product that proved unexpectedly costly for investors this year was target-date retirement funds. These funds mechanically increase the portion allocated to bonds each year as you approach and enter retirement. They generally hold a widely diversified portfolio of thousands of stocks and bonds. While this might be superficially appealing, there are significant problems to this approach.

First, there is little or no selection for what might be suitable for investors. These funds usually invest a portion of their portfolio in 20- to 30-year Treasury bonds, and this portion increases every year. The theory is that Treasury bonds are safer than stocks, so investors should own more of them as they approach retirement. However, they are only safer from recession risk, not interest rate risk. In fact, 20- to 30-year Treasury bonds are down more than 30% this year through October 31. Worse than stocks. And this is the “safety” part of the portfolio.

Just look at the interest rates

That’s what happens when interest rates start at historic lows and rise rapidly. No one can predict the future of interest rates. But if you saw that 30-year bonds were yielding 2% at the beginning of 2022, it was plain as day that investors would not do well holding them. The highest return you could expect if you were to hold the bonds to maturity is 2% a year, but you would risk substantial loss if interest rates were to rise to normal historical levels and you needed to sell before maturity. Likewise, even normal inflation would pose a large risk to returns, let alone the kind of inflation we’ve experienced this year.

In other words, you do not need to forecast interest rates to know when the risk/reward trade-off is clearly out-of-balance.

But to the firms promoting these products, it does not matter: They hold everything, regardless of value. That is, target-date funds are often composed of the “total stock market index” and the “total bond market index.”

Which brings me to another harmful idea that has become widespread: Diversification for the sake of diversification.

Investors don’t need to own everything

There is an idea finding favor in some academic circles that the ideal for investors would be to own a piece of all the assets in the world. According to this theory, the value and risk of individual assets does not matter; what matters instead is exposure to the “market portfolio.” In fact, this theory was taught to me in my finance classes.

In one form or the other, this idea has trickled into the popular consciousness. The result is that some people own a huge assortment of random investments, often acting at cross purposes or no purpose at all.

Going back to target-date retirement funds, they also follow this creed of diversifying for the sake of diversification. I was looking at one popular target-date 2025 retirement fund that had a large allocation to international bonds. For what logical reason would a typical U.S.-based retiree own a lot of international bonds? U.S.-based retirees’ expenses will be in U.S. dollars, so why would they take unnecessary currency risk? Especially when international bonds are neither more creditworthy nor offering a substantially higher yield.

Additional Reading: Understanding — and Working With — Target-Date Funds 

It is hard for regular investors to even know what they are getting in a target-date retirement fund: They are not transparent. They are mostly funds of other funds, so to understand what you are holding, you need to go down two layers and look at the holdings of the funds they own.

The bottom line is that doing what’s right for people requires thought. It’s not always easy, but any financial plan and investment strategy should be the result of understanding each person’s unique circumstances and figuring out the combination of strategies that is most suitable for their situation.

Randall Watsek, CFA, CFP, is a financial advisor at Raymond James. He has managed money for over 25 years, first as a credit portfolio manager at City National Bank and then as an equity research analyst, sector portfolio manager and quantitative researcher at DGHM, a quality value boutique. He leveraged this experience to start an investment advisory practice at Raymond James. Watsek earned an MBA from the University of Chicago in analytical finance and accounting, and a BA from Claremont McKenna College in economics and history. Any opinions are those of Randall Watsek and not necessarily those of Raymond James.


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