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.

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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