Posted by on Mar 7, 2016 in Articles & Advice, Blog, Columns, Featured |

Image Credit: Christophe Vorlet

By Jason Zweig |  Mar. 4, 2016 12:03 pm ET

For some people, the best way to hit the investment target is by not even taking aim.

With “target-date funds,” which hold a pre-selected basket of mutual funds and change it gradually over time, workers can invest for retirement with their hands tied behind their backs. Once they start investing, they never have to make another decision — and many never do.

It seems paradoxical that anyone could learn anything from people who do nothing. But even investing experts need to be reminded that the test of any action is whether it is better than inaction.

A study released this past week by Vanguard Group, the asset-management giant, looked at the behavior of nearly 18,000 participants in a corporate retirement plan with about $1.2 billion in assets. Between the end of 2014 and the middle of last year, the plan rolled its participants into a new set of target-date funds; employees could “opt out,” or choose to move their money into other choices, but that required them to make an active decision.

It turned out that 84% of the employees who were automatically moved to target-date funds stayed there.

That may have prevented some of them from taking too much risk. One in seven had at least 90% in stocks beforehand; after the shift to target-date funds, only half as many did.

Getting bumped into target-date portfolios also helps prevent investors from taking too little risk. Almost a tenth of the participants had less than 20% of their retirement money in stocks; after the shift to target-date funds, fewer than one in 100 savers was so underexposed.

True, most investment managers have a profit motive for promoting these funds. Target-date portfolios are cheap to run and generally earn higher fees for the managers than exchange-traded funds do. They are also the epoxy of the fund business: They glue investors’ money almost permanently into place.

Retirement savers in target-date portfolios trade only one-fourth to one-sixth as often as those in a mix of other funds, according to data from T. Rowe Price Group and the Vanguard Center for Retirement Research. Even in the darkest days of the financial crisis, most of these people did absolutely nothing.

Still, such inertia may be good for investors. Morningstar, the research firm, found last year that target-date funds earned an average of 5% annually over the 10 years through the end of 2014. But the typical investor in those funds earned 6.1% annually, or an average of 1.1 percentage points more per year.

That’s because the standard way of calculating fund returns measures the performance of a lump sum invested at the beginning and kept constant until the end. Real people, of course, add or subtract money along the way. But target-date investors, by never budging and automatically adding to their holdings with every paycheck, buy more when markets are down, giving their overall results a slight boost if stocks continue to rise.

Target-date investors, says Jeff Holt, an analyst at Morningstar, “are less prone to take matters into their own hands and move their assets around when markets are gyrating.”

Nevertheless, as another study released this past week shows, many people are resistant to the incredible power of investment inertia.

Financial Engines, a firm in Sunnyvale, Calif., that provides advice on retirement accounts, asked 1,000 plan participants about target-date funds. Among those who don’t rely heavily on these portfolios, more than half said they believe they can pick better funds themselves.

Yet earlier research by Financial Engines found that participants with little or no money in target-date funds underperform them by an average of 2.1 percentage points annually.

The great financial analyst Benjamin Graham wrote in his book “The Intelligent Investor” that there are two kinds of investors: defensive and enterprising. Graham’s distinction depends not on how much risk you want to take, but rather on how much energy and effort you want to put into investing.

If you are enterprising, you enjoy the challenge of trying to outsmart the market — and, therefore, will find a target-date fund boring and unsatisfying. If you are defensive, you don’t want the worry and regret that can come from frequent changes of course — so a target-date fund could suit you just fine.

But even enterprising investors need to be reminded that less can be more.

A classic study from 1992 found that fund managers could have added nearly one percentage point to their average returns each year if they had picked all their stocks on Jan. 1 and then gone on a year-long vacation, never trading at all.

​Over the past decade, as the blogger Ben Carlson recently pointed out, most of the nation’s largest endowment funds — for all their brainpower and experience — underperformed a mindless portfolio of three funds that simply mimic the stock and bond markets.

Doing nothing isn’t for everyone, but all investors should think twice before they do anything.

Source: The Wall Street Journal