Why Target Date Mutual Funds and Couch Potato Strategies may no longer work by Rico Dilello

mr-potatohead

By Rico Dilello

Both target date mutual funds and couch potato strategies are based on two concepts that bonds are less risker than stocks and asset allocation should be rebalanced based on age. Therefore, the closer you get to retirement, the larger portion of your portfolio should be in bonds and less in stocks.

These strategies have been around for decades and are very popular with investors. The other problem that hasn’t been address is that people are living longer. If you are 60 today, living in North America, your retirement nest egg will probably have to last for 25 to 30 years.

A brief explanation of Target-Date Mutual Funds

An investor would pick a projected date for their retirement. Thirty five years from now would have an investor select a 2050 target date mutual fund. The long time horizon would allow the fund manager to have more stocks and less bonds & cash in the fund. An older investor who hopes to retire in ten years would select a 2025 target date. Now the 2025 fund would hold more bonds & cash and fewer stocks. More bonds equals less risk and more protection against losses.

The fund’s managers then rebalance the fund’s assets each year and keep its investments on track to meet the fund holders’ goal of using that investment to begin paying for their retirement in a particular year.

What is the Couch Potato strategy? 

The Couch Potato strategy is a do it yourself technique for building a diversified, low-maintenance portfolio designed to deliver the returns of the overall stock and bond markets with minimal cost. Anyone can now build and maintain their own portfolio using index funds and exchange traded funds (ETFs). You would rebalance the portfolio based on your age and asset mix. For example; an investor in their early 50’s would have 50% stocks and 50% bonds & cash. If the stocks when up in value to say 60% of the portfolio than the investor would sell some stocks and buy more bonds.

The most common warning in the mutual fund industry is; “Past performance is no guarantee of future results.” It means that, despite the fact that past and future are often correlated, that correlation is not guaranteed! Something may happen in the future that never happened in the past or what happen in past will not continue into the future.

The major bull market in bonds has lasted for nearly 33 years. The 30-year Treasury yield hit all-time a high of 15.20% on Sept. 29, 1981 and the 10-year’s yield record high came the next day, at 15.84%. In contrast, today, the 30-year yield is 2.85% and the 10-year’s is 2.20%. How likely will this continue into the future?

US Treasury Bond Rates At 75-Year Low                                                          

The astounding chart below shows that the Fed has successfully forced Treasury bond interest rates to lowest level since 1940.

treasury

In my humble opinion, the bull market in bonds is over. Interest rates have no place to go but up. Fed chair, Janet Yellen wants to raise rates sometime in 2015 which will decrease the value of bonds and increase the yields. Even if interest rates moved up very slowly like they did between 1940 and 1955, can you afford to have half of your portfolio earning 2.5% interest for the next 15 years? The after tax return on bonds will not keep pace with inflation. Therefore the money that you have in bonds will be worth less in 15 years’ time but your living costs will be higher.

Foreign bonds are even worse with Q.E. in Japan and Europe causing negative yields on their bonds. Plus foreign bonds have currency and default risks added to their very low yields. There is little doubt that Greece will be forced to default on its debt down the road. News regarding Puerto Rico’s debt problems are making bond investors very nervous.

I believe that something has happen that didn’t happen in the past. Long duration bonds are more risker than stocks and are in a long term bear market. Plus government debt worldwide has never been higher as a percentage of GDP and continues to grow.

The major problem of using both of these strategies is increasing your bond exposure as you get older. Investors in their late forties and early fifties saving for retirement are in for a big surprise if they increase their exposure to holding more bonds as they get older. With interest rates near all-time lows, return on bond funds over the next 15 years will be well below historical averages. Using target date mutual funds and couch potato strategies will not produce a sizable retirement nest egg.

If you retired, like me, having a high percentage of bonds in your retirement portfolio will produce less retirement income. I personally don’t own any bonds but prefer high quality dividend paying stocks instead. I also have some cash on hand that earns very low interest but offers some safety.

With all this money printing worldwide, do you remember the hyperinflation crisis of the 1980’s?  I will never forget my bank offering me a 5 year fixed term mortgage at 21% when it came up for renewal in 1982! Lucky for me that I was smart enough to renew for only one year at 17.5% and interest rates came tumbling back down.

By Rico Dilello

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