Last week, I chatted with Dave Straffon at a jazz bar in Vienna, Austria. He works at the American International School of Vienna.
Long before he moved to Austria, Dave and his family lived in Kuala Lumpur, Malaysia. One night, five thieves woke them up. The intruders were armed with a screwdriver, a bread knife and a garden shovel. Each weapon belonged to Dave.
“They came in wearing the baseball caps that we kept downstairs,” said Dave. “The guy who tied us up was actually wearing four of them.” The couple feared for their lives. But the thieves didn’t hurt them.
Fortunately, most Americans who live abroad don’t have to be afraid. According to World Bank’s data on global homicide rates, many countries (including Malaysia) are far safer than the United States.
But there is one concern that many Americans share–whether they live abroad or not. They wonder if they’ll have enough money to retire. According to the American Benefits Council, nearly 80 percent of full-time American workers have access to a company defined contribution retirement plan, such as a 401(k).
But many investors get confused when they’re trying to pick funds. Financial representatives sometimes make things worse. They often give mind-numbing presentations when they try to explain their products. The host of Last Week Tonight, comedian John Oliver, says “It’s the kind of presentation that no one in their right mind really wants to sit through.”
But at some point, even John Oliver will have to pick some funds for his 401(k). That’s Dave Straffon’s challenge too. Raymond James is offering him 30 funds to choose from. That many offerings can create a deer-in-the-headlights syndrome. In Barry Schwartz’s book, The Paradox of Choice, he references a study of 401(k) plans. Employee participation rates are lower when there are more funds to choose from.
In a TED talk Schwartz said, “For every 10 mutual funds an employee was offered, the rate of participation went down 2 percent. If you offer 50 funds to choose from, you get 10 percent fewer employees contributing than if you offered five.”
So what combination of funds will give you strong results?
Most investors jump at funds with strong recent returns. But that doesn’t work. Funds that win during one time period rarely win the next. I asked Morningstar’s Russell Kinnel for the single best predictor of mutual fund performance. He said investment fees. The lower, the better.
So do you build a diversified portfolio with the lowest-cost funds that are available in your 401(k)? It’s not a bad idea. But another strategy might be even better. If your company offers Target Date funds, jump aboard that wagon.
Target Date funds are complete portfolios wrapped up into single funds. They make the selection process easy. For example, if you plan to retire in the year 2030, you could choose the Target Date fund with 2030 in its name. You wouldn’t need to buy another fund. Each Target Date fund contains U.S. and International stock market funds. They also contain bond funds. The fund company rebalances the holdings once a year. As the retirement date nears, more of the money gets shifted from stocks to bonds. This increases the fund’s stability.
Target Date funds are offered by all the major fund firms--- think Fidelity, Vanguard, T. Rowe Price and American Funds. But here’s an added bonus. Most investors in Target Date funds outperform investors who handpick individual funds for their 401(k).
Investors who handpick their funds often chase past returns. If a fund has done well, they add more money. If a fund does poorly, they sell or cease to buy. This ensures that investors often buy high and sell low.
Morningstar says most investors do this. In a 2014 study, they looked at average mutual fund returns over the ten-year period ending December 31, 2013. The typical fund averaged a 7.3 percent compound annual return. The typical fund investor averaged a 4.8 percent compound annual return. That’s quite a difference.
Over an investment lifetime, underperforming your funds by 2.5 percent per year could cut more deeply than a bread-knife wielding thief. Assume that a 30 year old invests $500 a month from age 30 until age 65. If the investor earned a compound annual return of 7.3 percent per year, the money would grow to a hefty $950,336.
But if the investor underperformed their funds by 2.5 percent per year (that’s in line with the Morningstar study) the same $500 invested each month would only grow to $544,952. That’s a lot less money to spend in retirement. The typical investor’s foolishness would cost them almost half. Don’t think a broker can save you from this mess. In this story, I explained how American Funds’ brokers can make bonehead moves. They can also cause their clients to underperform their funds.
Target Date funds in a 401(k) provide a solution to this mess. Their investors don’t have to think about individual fund performances.
U.S. News reported a study that focused on the investment behavior for T. Rowe Price’s fund investors. Those who invested in the firm’s Target Date funds reacted less to market volatility than those in the company’s individual funds. Investors who don’t react to things like market news, individual fund performances or volatility have far better odds of investment success.
Vanguard’s Target Date funds are a case in point. Over the past ten years, their average investor outperformed their fund by 1.02 percent per year. Target Date funds can calm the nerves. Most of these investors dollar cost averaged every month. It allows them to buy more units when their fund values dropped and fewer units when fund values increased.
Dave Straffon’s 401(k) plan offers a series of Target Date American funds. He’s going to choose the American Funds Target Date 2025 fund.
It’s diversified. It gets rebalanced once a year. It’s just the kind of fund that should help him sleep well at night–--as long as he locks the door.
Vanguard’s Target Date Fund Investors Outperform Their Funds
August 31, 2006 - August 31, 2016
|Target Retirement Fund||Symbol||Average Fund Performance||Average Investor Performance||Investors’ annual outperformance/underperformance|
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller, Millionaire Teacher and The Global Expatriate's Guide to Investing: From Millionaire Teacher to Millionaire Expat.