In previous posts I discussed several “factors” – characteristics of stocks – that can be utilized in portfolio construction to seek to improve equity (stock) returns over long periods of time (10-20 years) with a high degree of probability. Over the next 20 years, exposure to these factors brings with it a very strong probability of higher returns for the equities (stocks) portion of an investment portfolio.
Retirees face the challenge of managing their investment portfolios to ensure they have enough money to last throughout their retirement years. In this pursuit, factor-based investing emerges as a compelling strategy that can provide retirees with potential benefits and help them achieve their financial goals.
A Review: What is Factor-Based Investing?
Factor-based investing involves constructing a portfolio based on specific characteristics, or factors, that historically have been associated with higher returns. The factors with strong academic support include size (small cap) (when used in combination with other factors), price (value), high-profitability, and momentum. Other factors with varying degrees of academic support include low-investment, quality, carry (high-dividend) and low-volatility.
By diversifying their portfolio across several of these factors, investors have a higher probability of achieving superior long-term returns relative to investing in a “total stock market” index stock fund, over any given 20-year period.
Benefits for Investors.
Factor-based investing holds particular advantages for investors, compared to a low-cost, “total stock market” strategy for the equities portion of the investment portfolio.
- For Accumulators – Enhanced Wealth Accumulation: Early-in-their-career investors can benefit from strong exposure to these factors. By incorporating them into their portfolios, they can potentially bolster their accumulated retirement savings by the time they reach their desired retirement age.
- For Retirees – Greater Probability of Financial Security: Retirees can enhance the probability of passing on more wealth to heirs and/or avoiding outliving their nest egg, by including factor-based investing in their overall investment strategy. This is especially relevant in today’s market (as of July 2023), as large-cap growth stocks’ exceptionally high valuation levels indicate lower long-term returns for U.S. large cap stocks, when compared to small-cap value stocks.
Managing Risk.
By leveraging the potential for greater returns through factor-based investing, retirees can consider reducing their allocation to equities (e.g., from 70% to 60%) and increasing their allocation to high-quality fixed income investments (e.g., from 30% to 40%). A multi-factor stock / fixed income portfolio can provide comparable long-term returns with reduced volatility compared to a total stock market / fixed income portfolio.
This can help reduce the impact of severe market downturns on the portfolio’s value. Should another “Great Depression” or “Great Recession” even occur, in which stock market values plunge 50% to 80% (or even greater), retaining a more substantial portion of the value of the portfolio via a greater allocation to fixed income investments would likely be crucial for a retiree’s financial security.
Important Considerations.
While factor-based investing offers enticing advantages, it is essential to acknowledge some key points:
- Historical Performance: Factors can experience extended periods of underperformance, and past returns do not guarantee future results. As factors are discovered and are more widely known and implemented, there is a likelihood that the strength of the factors will diminish over time – perhaps by about one-third.
- Ongoing Research and Due Diligence. Factor-based investing requires diligent research and ongoing monitoring to identify and select the appropriate factors and investments for utilization in an portfolio. Academic research in this area, while generally robust, is not static. Much research is underway, for example, on some potential new factors, as well as on how best to apply the factors.
In Conclusion.
There are very, very few investment strategies that tend to “beat the market” over very long periods of time.
Factor-based investing presents a powerful tool for retirees to manage their investment portfolios during retirement years. By diversifying across different factors, retirees can potentially achieve higher returns for their retirement nest eggs, or they achieve similar returns to a total stock market portfolio with lower risk.
Dr. Ron A. Rhoades serves as Associate Professor of Finance and Director of the Personal Financial Planning Program within the Gordon Ford College of Business at Western Kentucky University. He teaches and has taught courses in Retirement Planning, Applied Investments, Advanced Investments, Estate Planning, Financial Plan Development, Personal Finance, Money & Banking, Risk Management and Insurance, and Principles of Finance. He is regarded as a national expert in the application of fiduciary duties to the delivery of investment and financial planning advice. Ron’s upcoming book, Mastering the Science and Art of Investing: Strategies for Maximizing Returns with Multi-Factor Portfolios, is due to be published later in 2023. Ron is also the author of Professor Money Bear’s Guide to Personal Finance, a textbook he provides free of charge to students in Western Kentucky University’s Personal Finance classes.
Dr. Rhoades’s financial planning and investment advisory firm, Scholar Financial, LLC, is now accepting new clients. Dr. Rhoades prefers to work with those individuals and couples with greater than $1m in financial assets who are approaching retirement or who are in retirement, and with executives. See this web site “For Prospective Clients” to learn more.