Saving for retirement isn't a top-of-mind concern for many working people.
But in reality, they may inadvertently be making costly mistakes, such as waiting too long before allocating funds to a retirement account and missing out on compound interest. Putting your money in the wrong type of asset is another potential money-losing blunder.
The traditional approach is to diversify exposure with stocks and bonds. But a simulated study, in which three finance professors compared popular variations of portfolio makeups to determine which outcome would provide investors with the most returns during their retirement years, has challenged this common wisdom.
The study, published in November 2023, compared eight mainstream approaches to retirement investing. They included target-date funds, which rebalance and reduce risk the closer you get to retirement by lowering stock exposure and increasing bonds; the 60-40 stocks-bonds split; a 100% domestic-stocks allocation; a 50% domestic and 50% international stock split; a 100% allocation to developed-country government bills; and static and dynamic variations between domestic and international stocks and bonds.
How each portfolio performed
A 100%-equity strategy, with 50% domestic and 50% developed-country stocks, outperformed the traditional balance of stocks and bonds, including target-date funds, the most popular type in 401(k)s.
"It has better ultimate outcomes on every dimension in terms of generating wealth, in terms of providing retirement consumption, preventing you from running out of money in retirement — all of these things, the all-equity strategy does better," Scott Cederburg, an associate professor of finance at the University of Arizona and a coauthor of the study, told Business Insider.
But Cederburg noted that the all-equity strategy had larger intermediate drawdowns than a balanced fund with fixed income. He added that an investor must be disciplined enough to ride out the market dips because selling at the bottom is not ideal.
The portfolio with 100% domestic stocks did just as well as the one split between domestic and international equities on average, Cederburg said. But this approach exposes an investor to more extreme events, such as market crashes. He added that this scenario would be especially bad if you were already retired and dependent on your portfolio and the stock market dropped.
Therefore, Cederburg pointed to the second-best contender as the portfolio comprising an equal split between domestic and international stocks, with a small percentage allocated to bonds. In this scenario, the split between equities and bonds is based on the 120-age rule, which requires you to subtract your age from 120 to determine the percentage allocated to stocks. In this breakdown, an investor must save 13% of their income to match the outcome of someone who saved 10% of their income only in domestic and international stocks.
Target-date funds came in fourth place, with investors needing to save 14% of their income to have the same outcome as those investing 50/50 in domestic and international stocks, Cederburg noted.
On the lagging end of the performance spectrum, a portfolio comprised solely of developed-country government bills saw the lowest returns. An investor who saves for retirement through bills would need to save 47% of their income to be as well off as the all-equity investor saving 10% in domestic and international stocks, Cederburg said.
Overall, the average wealth an investor accumulated by age 65 after allocating 10% of their income to government bills was $280,000. The same allocation in a target-date fund yielded $810,000. And for an all-equities portfolio, it was $1,070,000 — a $790,000 difference between the lowest-performing scenario and the highest, according to numbers from the simulation Cederburg provided.
In sum, the study found that an investor willing to take more risk by going all-in on stocks gets rewarded with higher returns at the cost of enduring steep drawdowns over the years.
"Of course, you are introducing a higher-risk portfolio that over time should have a higher level of returns and therefore a greater level of wealth," Jeremy Stempien, a portfolio manager and strategist for PGIM, a global asset manager, said. "And if the pure goal for retirement planning was to have the greatest amount of wealth at the end of your life as possible, then I think that may be a very merited financial plan."
The study also showed that the all-stocks investor was least likely to run out of money during retirement. If an investor follows the 4% rule, which assumes you can safely withdraw 4% of your portfolio annually, the probability of running out of money for those who'd saved in a target-date fund is 17%; in government bills, it's 36%; and in an all-stocks scenario, it's 8%.
But what works in theory may not translate to real life, particularly when you're factoring in human behavior: If someone in their retirement years sees a 30% market crash accompanied by bad economic news, they may panic sell and move to cash, missing the recovery period, Stempien added.
Equities have won in terms of returns over the last 100 years, David Blanchett, PGIM's head of retirement research, said. But he added that this thesis changes when you factor in other assets, such as commodities and real estate, which may seem less efficient in the short term but tend to perform better over long periods, especially when you factor in inflation risks.
At first glance, commodities may not seem to provide much in returns in exchange for a high level of risk in a single year, Stempien said. But over a 10-year period, commodities can be very valuable, particularly when adjusted for inflation, Stempien added.
The backdrop of the study
The finance professors conducted the study as a back test with the block-bootstrap method, a simulation that uses historical averages based on broad market returns from 38 developed countries between 1890 and 2019. The study looked at a 10% income allocation of an investor aged 25 to 65 with an average saving amount of $240,000. The study included retired years based on randomized lifespans up to 120 years, Cederburg said.
The table below represents the eight portfolio scenarios the simulation used. The target-date fund combines domestic and international stocks, bonds, and bills. It's based on a glide path that begins with more equity early and less as the fund nears retirement. Though there are variations of target-date funds, it's based on the weights of typical target-date funds one of the largest investment firms offers..
