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Good Trumps Perfect

Adam M. Grossman

EARLIER THIS MONTH, The Wall Street Journal carried a seemingly innocuous article by Derek Horstmeyer, a finance professor at George Mason University. Horstmeyer described an analysis he and his research assistant had recently conducted. The question they sought to answer: Could investors achieve better results in their 401(k)s by avoiding target-date funds and instead constructing their own portfolios?

If you aren’t familiar with them, target-date funds are intended as all-in-one solutions for investors. They include stocks, bonds and other assets in a mix that’s geared to investors’ intended retirement date. As that target date nears, the funds automatically shift to a more conservative allocation. Because they do a reasonable job approximating investors’ needs, these funds are the default option in many plans.

Despite target-date funds’ popularity, Horstmeyer concluded that investors might be better off avoiding them. According to his analysis, a portfolio of individual funds—the alternative to an all-in-one fund—might boost an investor’s returns by two or three percentage points over a 10-year period.

Horstmeyer included some caveats. His recommendation, he said, was best suited for investors who were “adventurous and diligent” and also on the younger side. Still, critics quickly pounced. One wrote that his advice was “not very practical.” Another called it “ridiculous” and “irresponsible.”

Morningstar’s Jeffrey Ptak offered a more balanced critique, along with an important insight. Ptak acknowledged that target-date funds “aren’t perfect,” but pointed out that they deliver a key benefit: They make the investment process automatic, so investors don’t need to construct their own portfolios from scratch. In Ptak’s view, this benefit outweighs the small amount of theoretical underperformance that Horstmeyer identified.

Ptak summed it up this way: “Good>perfect.” I think that’s an important point. It’s all too easy to get hung up on the minutiae of personal finance—tax strategies, withdrawal rates, rebalancing schedules and so forth. To be sure, you don’t want to ignore those topics. But it’s counterproductive to focus on the details if it gets in the way of seeing the big picture. That, in Ptak’s view, happens frequently. Investors, he says, “struggle with decisions… especially when emotions are involved.” I agree—and when it comes to money, emotions are almost always involved.

For this reason, Ptak recommends that investors avoid pursuing mathematical perfection with their finances. “Could [investors] choose an allocation that was theoretically more tailored to their goal and circumstances? Yes. Could they come up with a trading and rebalancing scheme that would yield better risk-adjusted returns? Perhaps. Is there a more bespoke glide path for their situation? Could be. But each of these things… demands some kind of action or decision.”

That’s the challenge. In theory, you could do better. But in practice, it isn’t always so easy. As I often say, without a crystal ball, it’s awfully hard to get things exactly right. That’s why, counterintuitive as it seems, often the best solution is the one that is simplest and quickest—and, as a result, easiest to implement—and not the one that, in theory, is optimal.

When else might you apply this principle of “good>perfect”? Below are four other questions for which a good solution may trump one that is, in theory, optimal.

1. If I have surplus cash, should I invest it or use it to pay down my mortgage? This is a frequently asked question. Strictly according to the math, with interest rates as low as they are today, you’d be better off investing your surplus funds. Suppose, for example, that your mortgage rate is 3%, but you’re able to earn 7% in the stock market. In that situation, it would seem like an obvious decision to allocate every extra dollar to stocks. On paper, that would be optimal.

But it would also ignore two realities. The first is that the stock market sometimes goes down. That would turn this calculation on its head. Second, paying down your mortgage—especially if you can recast—provides several non-quantifiable benefits, including peace of mind and margin for error in the event of a rainy day. Bottom line: It might be “optimal” to allocate extra dollars to stocks. But in practice, the better choice could be to allocate those extra dollars to reducing debt.

2. In my 401(k), should I choose the Roth option or the standard tax-deductible option? This is another question on which the math seems clear. If you’re currently in a high tax bracket, conventional wisdom says you should choose the standard option, getting an immediate tax deduction but knowing you’ll owe income taxes on your eventual withdrawals. The assumption here is that your tax bracket will be lower when you’re retired.

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But that ignores the fact that tax rules can change, as we’ve seen multiple times in recent years. Also, there’s no way to forecast how quickly your assets will grow over time. While it may seem unlikely, I’ve seen more than one retiree stuck in the top tax bracket for the duration of retirement because of sizable required minimum distributions. The solution that appears optimal today may or may not be the one that turns out best in practice. What to do? If you aren’t sure, simply split your 401(k) contributions evenly between the tax-deductible and Roth options. As I’ve noted before, there’s nothing wrong with splitting the difference.

3. When should I rebalance my portfolio? There are many philosophies on rebalancing. One is to rebalance whenever the asset allocation in your portfolio deviates from your targets. Another is to rebalance only on a schedule—quarterly or annually, for example. Researchers have studied this question and identified, based on historical data, the optimal solution: You should rebalance when your asset allocation deviates more than 20% from any of your targets. That’s been proven to be optimal.

But if you manage your portfolio yourself and wanted to adhere to that rule, you’d have to monitor your asset allocation closely and continuously. The better approach, therefore, might be the “sub-optimal” solution: Mark your calendar and simply rebalance once a year. The research says this isn’t the best way, but I think it meets a higher standard: It’s actually feasible. As Ptak puts it, the optimal solution is the one “an investor can handle and stick with.”

4. In retirement, what is a safe withdrawal rate from my portfolio? There is, of course, the so-called 4% rule, but not everyone agrees on this. Some argue that 4% is too aggressive in light of today’s low interest rates. Meanwhile, the inventor of the 4% rule himself used a higher number.

Those aren’t the only complications. There’s also the fact that investors’ portfolios differ from one another, and that people’s spending needs change over time. Maybe most significantly, there’s the fact that the original 4% rule was designed to ensure a retiree could weather a 30-year retirement. As you get older, though, you can afford to bump up your withdrawal rate. If you’re 85, you need not limit yourself to 4% withdrawals the way you did when you were 65.

Because of all these factors, the topic of withdrawal rates has been analyzed, discussed and disputed literally for decades. Yes, you could try to optimize this math—but you’d still be contending with all those variables. What would be the alternative? One straightforward solution is to use the same percentages that the IRS uses to set required minimum distributions (which these days aren’t required until age 72). These start at 3.6% at age 70 and then gradually rise to 5.3% at age 80, 6.8% at 85 and 8.8% at 90. Is this approach optimal? A more formal analysis might yield a better result. But I see this as another area where the strategy that’s best is the one that’s most feasible.

Morningstar’s Christine Benz sums it up well: Rather than driving ourselves crazy overanalyzing investment questions and striving for mathematical perfection, investors should redefine “optimal.” Make financial choices, she advises, that “impart peace of mind and are simple, livable and low maintenance.”

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

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John Wood
John Wood
5 days ago

Another great article, Adam.

On the question of paying down the mortgage or investing in stocks, I rarely hear credence given to the “cost of funds” for investing in stocks in this scenario.

To your example, if your mortgage is 3% and the perceived return on stocks is 7%, I view the real return on the stock option as 4%, because that money could have reduced 3% debt, so continuing to carry that debt results in a 3% “cost of funds” for the stock investment.

Thus, in my view, the question is 3% guaranteed return to pay down debt, or 4% non-guaranteed, potential real return to invest in stocks.

The other reward for paying down debt that I rarely hear cited is the
elimination of the monthly mortgage payment years ahead of schedule. That future monthly windfall can then be invested in stocks with 0% cost of funds.

Mark Royer
Mark Royer
5 days ago

Excellent as usual. As for “splitting the difference” on the 401k re Roth vs. traditional, if you get a company match, that will go into the traditional side of your 401k, so you investing in the Roth side will split the difference nicely.

Of course there are exceptions. I did the traditional side completely while working in California, then switched the the Roth contributions when I moved to Texas which has no state income tax. Now retired, I am moving as much to the Roth IRA (converted the 401k earlier to avoid RMDs) as tax issues allow, until the RMDs begin at 72.

Roboticus Aquarius
Roboticus Aquarius
7 days ago

Great article, Adam!

I think it all boils down to ‘know thyself’: psychologically, but also what your financial condition can handle.

I arbitrage. Extra cash is going into the market, not my mortgage. It doesn’t bother me to have a mortgage.

Cash flow was my biggest concern for a long time, so my 401K contributions were traditional. Now I have enough saved that it will grow into enough for retirement… and have strong cash flow. Therefore I’ve switched to investing 100% Roth (employer contributions will still hit Traditional though). My Roth will never catch up to my Traditional, but I may get a little tax flexibility out of it. I’ve also started saving after tax, for flexibility before age 59.5.

I use 5% rebalance bands. That had me rebalancing into stocks on March 23, 2020. Man, it doesn’t get better than that; I won’t ever get that lucky again… but balance bands suit my temperament.

I have a cash flow model for withdrawals. I expect to pull out perhaps 6% in early retirement, and somewhat less later on. That along with sequence of returns risk means higher risk up front, so I factor the need for risk management into my savings and retirement considerations.

BMORE
BMORE
11 days ago

Adam’s comprehensive reviews seems on target—especially since Vanguard recently announced they are merging individual and less expensive institutional target date funds, now with fees .09% or lower. This reduces much of the costs that accounted for the increased yield in the analysis.

https://www.thinkadvisor.com/2021/09/28/vanguard-merging-retirement-funds-cutting-fees-adding-a-new-option/

Purple Rain
Purple Rain
11 days ago

“When should I rebalance my portfolio?”

How about never? I am a buy and hold dividend growth investor. Once I buy something, I don’t tinker with it in any way. I don’t hold bonds (except I-Bonds), so I never rebalance.

I follow the example of Voya Corporate Leaders Trust (LEXCX). The Trust bought bought 30 of the Great Depression’s major companies in 1935. Never traded a single stock in it, except if a company suspended its dividend or was in danger of being delisted or going bankrupt. It did sell Citigroup(C) in 2009 when the share price fell to just $1. It has handily beaten the S&P 500 with pure sloth.

Over the years, most of its initial holdings have been sold to other companies. And Berkshire Hathaway features on its list of holdings after Buffett used BRK shares to acquire Burlington Santa Fe.

https://www.morningstar.com/articles/960641/the-strange-and-happy-tale-of-voya-corporate-leaders-trust

John Wood
John Wood
5 days ago
Reply to  Purple Rain

I’m inclined to agree, Purple Rain. If, as some research as indicated, it’s better to cut your losers early and let your winners run, rebalancing would seem to work counter to that theory. Does one really want to sell some of their stock portfolio to buy more bonds, currently?

macropundit
macropundit
8 days ago
Reply to  Purple Rain

I’ve been the same way. Yeah, I heard about Voya a few weeks ago. Wild story. That’ll be my retort to those who point to market cap leaders lists to show some changes from one decade to the next to declare owning individual stocks extremely dangerous. Of course I think most shouldn’t, but that’s not absolute and I’ve always owned only individual stocks outside of 401k. Then if you beat the market significantly, I mean really not just pretend, the people with the charts will declare it (pure) “luck”. (Of course all things in life do depend on luck to an extent.) Which only goes to show the wisdom of Keyne’s perceptive maxim:

“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

You gotta decide what game you’re playing. I’m playing the wealth game not the reputation game.

David Powell
David Powell
11 days ago

Great piece, this one belongs in the “classics” section of HD.

Practical, resilient solutions you can happily stick with through good times and bad are always reasonable but not necessarily strictly rational.

Rick Thompson
Rick Thompson
11 days ago

Another great article, Adam. To quote from my literary hero, Henry David Thoreau: “Our life is frittered away by detail. Simplify, simplify, simplify!”

MikeinLA
MikeinLA
11 days ago

Call I confirmation bias, but this is a very sensible article. The Morningstar folks are big believers in “don’t let perfect be the enemy of the good.” I’ll happily get most of the investment stuff right (401k contributions, index investing, etc) and have peace of mind rather than squeeze the last basis point out of my ROI. Thanks for the comfort!

Ormode
Ormode
11 days ago

“While it may seem unlikely, I’ve seen more than one retiree stuck in the top tax bracket for the duration of retirement because of sizable required minimum distributions”
For a single retiree, that implies a retirement income over $518,000, with a retirement account of at least $12 million. I’ll tell you what, give me the account, and I’ll deal with paying the tax!

Ocher
Ocher
11 days ago

Thanks for this thoughtful discussion of the benefits of simplicity in managing our financial affairs and preparing for retirement. The concept of Occam’s razor comes to mind. While optimal financial balancing of our assets is possible with more active involvement in adjusting our portfolios, the peace of mind associated with having to make fewer decisions less frequently (e.g., rebalancing once a year or once a quarter) frees up time and energy for other pursuits such as travel, family, and leisure time activities. Great column Adam.

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