If you’re saving for retirement, a broad market index portfolio is usually a good option. For example, investing in a target date fund or an S&P 500 index fund is a low-cost way to gain broad market exposure. However, newly published research indicates that there may be a significantly more lucrative way to spend your nest egg.
An analysis from Dimensional Fund Advisors shows that retirement savers can do better than following the standard advice of using index funds, for example, to achieve a balanced portfolio. According to the DFA research, portfolios built with an emphasis on size, value and profitability premiums can generate more assets and longer lifespans than broad market portfolios. In fact, a DFA researcher calculated that a portfolio that emphasizes these premiums would make a hypothetical investor at least 20% more money at age 65, even if market returns were lower than the historical average.
“These results are encouraging. A portfolio with a controlled, moderate exposure to premiums can balance higher expected returns than the market with the costs of slightly higher volatility and moderate tracking error,” wrote Mathieu Pellerin of DFA in his paper “How Targeting the Size, Value, and Profitability Premiums can improve pension results.”
“As a result, targeting these long-term drivers of stock returns is likely to lead to wealth growth early in retirement.”
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What are size, value and profitability premiums?
As part of its research, DFA compared the simulated performance of a broad market index portfolio – represented by the Center for Research in Security Price (CRSP) 1-10 index – with that of the Dimensional US Adjusted Market 1 Index.
The DFA index includes 14% fewer stocks than the CRSP index and places a greater emphasis on size, value and profitability premiums. Here’s how the company defines each:
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Size premium: The tendency of small-cap stocks to outperform large-cap stocks
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Premium value: The tendency for undervalued stocks – those with a low price-to-book ratio – to outperform
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Profitability premium: The tendency of companies with relatively high operating profits to outperform companies with lower profitability
As a result, the DFA index is more heavily weighted in small-cap and value stocks, as well as companies with higher earnings.
Premiums ensure better pension results
To test the long-term viability of its premium-based portfolio, DFA ran an extensive series of simulations and compared the results to the CRSP market index.
First, Pellerin calculated a hypothetical 40-year return for each portfolio, assuming an investor starts saving at age 25 and retires at age 65. Both portfolios are part of a glide path that starts with a 100% equity allocation and transitions to bonds at age 45. At age 65, the investor’s asset allocation eventually reaches a 50/50 split between stocks and bonds.
He then calculated how both portfolios would perform during the investor’s decumulation phase. DFA has applied the 4% rule for this. This rule of thumb states that a retiree with a balanced portfolio can withdraw 4% of his assets in the first year of retirement and adjust withdrawals for inflation in subsequent years, and have enough money for 30 years.
DFA tested the portfolios based on both historical returns (8.1% per year) and more conservative returns (5% per year).
Applying historical returns, the premium-focused portfolio would be worth 22% more than the broad market portfolio by the time the hypothetical investor reaches age 65. In the lower growth environment, DFA portfolios would still deliver 20% more median returns. assets than its counterpart, the study found.
The hypothetical investor would also have a lower chance of running out of money with the DFA portfolio. Based on historical returns, the premium-oriented portfolio failed only 2.5% of the time after a 30-year retirement. That is almost half as often as the market portfolio, which recorded a failure rate of 4.7%.
That spread became even greater when Pellerin ran the simulations with more conservative return expectations. Over the course of a thirty-year retirement, the DFA portfolio ran out of money in only 12.9% of simulations, while its annual return was only 5%, while the market portfolio failed 19.9% of the time.
A financial advisor can help you create a diversified portfolio that suits your goals. Make a match with a financial advisor today.
In short
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 found that focusing on stocks with size, value and profitability premiums can yield better retirement results . When a broad market index is compared to an index that focuses on these factors, the latter produced at least 20% more median assets and had lower failure rates.
Retirement planning tips
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How much savings will you have by the time you retire? SmartAsset’s retirement calculator can help you estimate how much money you can expect to have by retirement age and how much you may need to support your lifestyle.
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Retirement planning can be complicated, but a financial advisor can help you through the process. Finding a financial advisor does not have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can have a free introductory meeting with your advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuations like the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But with a high-interest account, you can earn compound interest. Compare savings accounts from these banks.
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