This type of portfolio could help you retire with 20% more money than index funds

If you’re saving for retirement, a large stock index portfolio is usually a good option. Investing in a target date fund or an S&P 500 index fund, for example, is an inexpensive way to gain broad market exposure. However, recently published research indicates that there could be a much more lucrative way to manage your nest egg.

A financial advisor can help you find the right combination of investments for your retirement portfolio. Find a fiduciary advisor today.

Analysis by Dimensional Fund Advisors suggests that retirement savers can do better than follow the standard advice of using index funds, for example, to achieve 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 DFA research. In fact, a DFA researcher calculated that a portfolio that emphasizes these premiums would leave a hypothetical investor at least 20% more money at age 65, even if market returns were below average. historical.

“These results are encouraging. A portfolio that incorporates controlled, moderate premium exposure can balance higher-than-market expected returns against the cost of slightly higher volatility and moderate tracking error,” wrote Mathieu Pellerin of DFA in his article “How Targeting the Size, Value and Profitability Bonuses Can Improve Retirement Outcomes.”

“As a result, targeting these long-term drivers of stock returns is likely to increase assets in early retirement.”

What are size, value and profitability bonuses?

This type of portfolio can help you retire with 20% more money than index funds

This type of portfolio can help you retire with 20% more money than index funds

As part of its research, DFA compared the simulated performance of a broad portfolio of market indices – represented by the Center for Securities Pricing Research (CRSP) 1-10 Index – to that of the Dimensional US Adjusted Market 1 index.

The DFA index includes 14% fewer stocks than the CRSP index and places greater emphasis on size, value and profitability premiums. Here’s how the company defines each:

  • Size premium: The tendency for small cap stocks to outperform large cap stocks

  • Value premium: The tendency for undervalued stocks – those with low price-to-book ratios – to outperform

  • Profitability bonus: 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 higher earning companies.

Bonuses produce better results in retirement

This type of portfolio can help you retire with 20% more money than index funds

This type of portfolio can help you retire with 20% more money than index funds

To test the long-term viability of its premium-based portfolio, DFA performed a comprehensive set of simulations and compared the results to the CRSP market index.

First, Pellerin calculated 40 years 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 descent plan that begins with a 100% allocation to equities and transitions to 45-year bonds. At age 65, the investor’s asset allocation eventually reaches a 50/50 split between stocks and bonds.

Next, it calculated how the two portfolios would perform during the investor’s decumulation phase. To do this, DFA applied the 4% rule. This rule of thumb states 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 to 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 premium-targeted portfolio would be worth 22% more than the broader market portfolio by the time the hypothetical investor turns 65. In a lower growth environment, DFA portfolios would still offer 20% more median value assets than its counterpart, according to the research.

The hypothetical investor would also be less likely to run out of money with the DFA wallet. Using historical returns, the premium-focused portfolio only failed 2.5% of the time over a 30-year retirement. This is almost twice as much as the market portfolio, which has a failure rate of 4.7%.

This gap widened further when Pellerin ran the simulations with more conservative return expectations. During a 30-year retirement, the DFA portfolio ran out of money in only 12.9% of simulations when annual returns averaged just 5%, while the market portfolio failed 19, 9% of the time.

Conclusion

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 has found that targeting stocks with size, value and profitability can produce better results in retirement. When comparing a broad market index to one that focuses on these factors, the latter produces at least 20% more median assets and has lower failure rates.

Retirement Planning Tips

  • How much savings will you have when you retire? SmartAsset’s Retirement Calculator can help you estimate how much money you can expect to have when you reach retirement age and how much you’ll potentially need to support your lifestyle.

  • Planning for retirement can be complicated, but a financial advisor can help you through the process. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three approved financial advisors who serve your area, and you can have a free introductory call with your advisor to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.

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