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The Smart Take:
In this episode, Tyler Emrick, CFA®, CFP®, explores why targeting a “magic number” of retirement savings falls well short of good retirement planning. Yet, why do people often focus on this? Is it because this survey data is regularly done and widely in the media – with the magic number now at a record high of $1.46 million – or something more?
Instead of magic numbers, hear Tyler discuss topics such as maximizing Social Security benefits, implementing a diversified investment portfolio, adding alternative strategies to your portfolio, and more. All of these can combine to help you build a more robust retirement plan tailored to support and protect your retirement lifestyle.
Here’s some of what we discuss in this episode:
- The amount of money investors believe they need to retire has increased dramatically and is exceeding the current pace of inflation.
- What has been the driving force behind the increase?
- Why you should be careful when using a magic number.
- The financial items you should be focusing your attention on instead.
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The Hosts:
Kevin Kroskey, CFP®, MBA – About – Contact
Tyler Emrick, CFA®, CFP® – About – Contact
Episode Transcript:
Tyler Emrick:
Today, we’re going to dive into the intricacies of retirement planning beyond conventional wisdom to explore why the notion of a magic number for retirement savings falls just short and discover holistic strategies for achieving financial security. From maximizing social security benefits to exploring alternative investment strategies, it’s all coming up today on Retire Smarter.
Walter Storholt:
Hey, welcome back to another edition of Retire Smarter. I’m Walter Storholt alongside Tyler Emrick. We’ve got a great show on the way today. Got to dive into a couple of different topics that I think really help provide some excellent insight into advancing our knowledge in the financial landscape. If you’re new to the show, Tyler Emrick is a wealth advisor and CERTIFIED FINANCIAL PLANNER at True Wealth Design based in Northeast, Ohio, but with offices also in Southwest, Florida and the greater Pittsburgh area. And you can meet with the team anywhere from online at TrueWealthDesign.com. Tyler’s also a chartered financial analyst and just always a pleasure to talk to here on the show. Tyler, how’s life treating you these past few weeks?
Tyler Emrick:
All right. Well, doing okay. It’s springtime. Weather’s turning out pretty well around here in Northeast, Ohio, so we’re pretty pumped. Coming off a good Mother’s Day, got to go out to eat and enjoy some time with family. So yeah, no complaints on this time of year from me.
Walter Storholt:
Where was the Mother’s Day outing location this year?
Tyler Emrick:
The Mother’s Day outing location was actually, we went to Emily’s house and had some dinner.
Walter Storholt:
Oh, nice.
Tyler Emrick:
And then we actually cooked, yeah, and most of our family’s out of town, so we had my wife’s mother actually come into town for a week, which is awesome to have her in. And then my extended family here up in Cleveland is where we were at. So yeah, no, it was good. And a couple dinners at a couple restaurants. We didn’t make it to the old infamous Applebee’s that I feel like I speak about the time here on the pod.
Walter Storholt:
I was wondering if that was going to pop up.
Tyler Emrick:
But yeah, no, few dinners here or there. Believe it or not, on Mother’s Day, my wife had a craving for McAlister’s, which is not close to our house, so we did get to make the trip about 40 minutes or so, drive one way, but McAlister’s was a pretty big success and we got to eat it at the house.
Walter Storholt:
That’s probably my favorite deli chain is McAlister’s.
Tyler Emrick:
Is it? I’m surprised you’ve heard of it. I feel like there’s not too many around, at least here where we’re at, and for whatever reason, yeah, we think it’s good as well.
Walter Storholt:
Yeah, there were several in North Carolina, so that’s where I got exposed to them. I haven’t seen any in Colorado. I need to look them up and see if I can find any around here.
Tyler Emrick:
Yeah, definitely. Yeah, it hit the spot and yeah, it was good. Yeah, they get these huge, massive big potatoes.
Walter Storholt:
Yes, yes, they do have big potatoes.
Tyler Emrick:
Ton of carbs is always good on the agenda.
Walter Storholt:
Yeah. Yeah, they got a lot of good stuff there. So free plug for McAlister’s Deli.
Tyler Emrick:
Yeah, for McAlister’s, absolutely.
Walter Storholt:
Awesome. Well, hey, I’m looking forward to talking about what you have on the agenda today, Tyler. I’m looking forward to your setup here. I know you probably always perk people’s ears up whenever you talk about alternative investments, and I know that’s a piece of the conversation today. It just seems like people get very interested in alternatives and other ways of doing things. There’s something maybe exotic or kind of sexy about it that maybe draws extra eyeballs and ears, and so I look forward to your perspective on that and more today.
Tyler Emrick:
Yeah, no, absolutely. I mean, it’s a topic I don’t think we cover too frequently in the podcast here, so I think it’ll be good. Can get a little bit granular, but that’s okay. I think we like that. And what we’re, I guess, going to talk to about alternative investments in relation to is really portfolio diversification, which actually is going to come up from really, I guess as you think about the setup today, it’s going to come from a study that came across my desk over the last month.
We reference studies all the time here, but this one in particular was fascinating to me at least because it was really trying to get down to and ask retirees and US adults what they feel they need to retire on. And what I mean by that is what is this magic number or how much assets do you need to hit to be able to retire comfortably? I think about that. I don’t know. You remember that old commercial where people were just walking around with the numbers above their head, the orange, I think it was for ING.
Walter Storholt:
I do.
Tyler Emrick:
Did you ever see that?
Walter Storholt:
And it must be effective advertising because I still remember it to this day, and I hear it mentioned a lot and talked about, so it was good advertising back in the day for sure.
Tyler Emrick:
Oh, absolutely. I don’t know too much about ING, I don’t even know if they’re still around, but that commercial.
Walter Storholt:
But I remember them and I remember the signs, and that’s what you really want in a commercial, right? Because sometimes you see a good ad, but then you can’t remember who it was for. And that’s to me not as effective. Right?
Tyler Emrick:
Yeah, no, that’s right. So this study essentially asked, I think it was around 4,500 adults, that is exactly what it was what they felt they needed to retire on from a dollar value standpoint. And I think they’ve been running this study for a little over 10 years now. So they got some pretty good data. And what kind of poked my interest after reading it was the actual numbers that came back in the study. So the magic number that those 4,500 adults came back and said they needed to retire was just under $1.5 million to head into retirement with. I don’t know, Walt, does that seem fairly reasonable to you or any initial gut reaction from 1.5 million is what you need to retire on?
Walter Storholt:
And I know a lot of folks are going to go, “Ooh, okay, that sounds a little out of reach or little steep.” Yeah.
Tyler Emrick:
Fair enough. Yeah, well, it’s actually a pretty hefty increase. I mean from the last year’s survey, that number was just under 1.3 million.
Walter Storholt:
Oh, that is a big jump.
Tyler Emrick:
Yeah. About 15% and then if we go back even just a little bit further to the 2020 study, it’s about a 50% increase from the number that came through on that study, which was a little about close to one million, which I don’t know why one million kinds of sticks in my head or the number that I hear quite frequently, but it seems like a lot of families that come in, they’re like, “Well, hey, we don’t have a million dollars saved for retirement, are we going to be okay? And are we going to be able to do that?”
Walter Storholt:
Yeah, it’s going to be … I mean, that just kind draw on the floor moment there. I think that that’s an appropriate pause there for a moment just because, wow, 50% increase in that short amount of time, that definitely just feels like out-of-control inflation. How can we possibly keep up with those demands?
Tyler Emrick:
Yeah, well, you hit the nail on the head. I mean, I think there’s a number of factors into it. I mean, you look back over the last four years, inflation, certainly geopolitical turmoil, rising interest rates, I mean, there’s been no shortage of headlines for us to gravitate to and have and formulate opinions about. And another I guess statistic that came out of that study was about a third of adults say they didn’t feel financially secure, which was also a pretty hefty jump from about, it was a little closer to 25% on last year’s study. So that’s what really jumped out at me was that was the highest level of insecurity recorded in their study going back well over 10 years. It seems like the populace, or at least the populace that they studied doesn’t paint a very glorious picture about just retirement planning and what would be needed to retire on and how they’re hitting those goals.
And two, I wouldn’t say that some of these negative feelings have really changed the behaviors of those individuals that were included in the study as well. Because you look at some other data points that jump out at me from it, its overall savings actually had dropped year over year. And when I say savings, I think of it in terms of specifically designated for retirement. It’s hovering around the average US adult has just under $90,000 saved for retirement, far, far cry from that 1.5 million roughly that the survey results came back and said that they think they need to retire on. And this under-savings really isn’t changing people’s behaviors from a spending standpoint because just under 60% of those surveys also said that they were going to spend the same or more this year and discretionary spending. So discretionary spending, just think vacations, restaurants, going out to Applebee’s, those types of things that we generally spend our excess spending on.
Walter Storholt:
I’m going to have to make an Applebee’s sounder if you keep bringing up Applebee’s every episode.
Tyler Emrick:
I know. I got to be careful of, I got to be careful, especially considering it’s not even one of my top places to go. But so it can be a little bit disheartening. I mean, at least from me looking at it and reading into it, it’s like, “Well, it seems like a lot of individuals and a lot of families think that they have this astronomical savings number that they need to hit heading into retirement and they feel very underprepared and that they’re really not tracking well towards actually accomplish those goals.”
So I figured today, we would take some of that data and maybe dissect this use of a magic number and maybe reframe it a bit and give our two cents on how we think that you should approach leading up to retirement and goals and what numbers that you think you should hit. And then we will finish up the podcast with where I think it would be a better use of your time to focus on as opposed to, “Hey, we got to hit $1.5 million or we got to hit a million bucks,” or whatever the case is, but what are some actionable, true decisions that are going to come up leading up to retirement and into retirement that truly move the needle and really put you in a better foot forward and a better situation heading into retirement.
So I just feel like they’re a little bit better use of your time as opposed to that just focusing on hitting some type of asset level. And some of the things that we’ll talk about are things we’ve talked about through multiple podcasts like social security, but then we’ll also get down into a little bit more granularity on diversifying or alternative investments and portfolio construction to kind of finalize the podcast. So I think we got a pretty good one playing for us today, and we’ll dive in and get a little bit of granularity there.
Walter Storholt:
That’ll be helpful because I feel like this is a nice collision of you know what, I understand that there are other layers to this and at the same time that magic number can be daunting, but it’s also nice how simple it is, and in such a complex financial world, simplifying things is always a nice goal. And so just having, if you could just say, “Hey, reach this number and you’ll be fine.” It at least gives you something simple to shoot for and feel good about.
Tyler Emrick:
It does.
Walter Storholt:
Unless that number becomes so big that then it becomes daunting to people, then I guess it has the reverse effect. But yeah, it’s an interesting collision of those different ideals, I suppose. So as usual, you’ll provide us with lots of great context as to why it’s always helpful to dig a little deeper.
Tyler Emrick:
Yeah, absolutely. Well, and I subscribe to the KISS theory in every situation possible, right? There’s an elegance about keeping it simple and understanding, but you need to know some of the pitfalls, especially if you’re trying to build a retirement plan around a specific number. I think that’s where it maybe falls short a little bit. And when we go back to that commercial from ING where again, every individual was walking around, they had a number over their head that they were shooting for. I think one thing that commercial does relay is that everybody’s number is different, and that’s important.
So kind of synthesizing it down and saying, “Well, hey, magic numbers 1.5 million is what you need to retire on,” I think really misses the boat and really misses the intricacies and the nuances of just our personal lives and what we’re trying to accomplish. There are a number of families that I’ve worked with in the past and worked with still that have not saved a million and a half dollars, but yet they’re living a very, very happy retirement and accomplishing just about every goal that they’ve set for themselves. So not everybody’s magic number per se is going to be the same. And then two, I feel like sometimes when we try to synthesize down complex topics into something extremely simple, the use case for that simple number can get misled. I don’t know how many times have we talked about withdrawal rates and generic rules, like the 4% rule. I feel like we’ve covered-
Walter Storholt:
They come up all the time. Yeah, retirement rules gone awry, did a whole series on it, right?
Tyler Emrick:
You got it. I think we want to be careful on taking a number like that and then using it to say, “Well, hey, I can apply this general rule that I can get 4% return per year from it and that my money will last me throughout the entirety of my retirement.” I don’t think that’s necessarily the case. I guess if you talked to James Ramsey, that was what? 8% was the withdrawal percentage that he thought was going to be applicable there-
Walter Storholt:
Some high expectations there.
Tyler Emrick:
… [inaudible 00:12:54] on that back in November. Yeah, absolutely. But I think that understanding and saying, “Hey, everyone’s number or magic number is going to be different.” And then two, the tools that everybody has in their toolbox to help them through retirement is going to be different. A lot of us might have social security, some of us might have pension plans, some of us might have 401K or more money in Roth, and less money in pre-tax. And all of these things are going to make up your specific situation and will give you decision points that are going to make your plan that much more successful if you take advantage of them the right way.
So I think a much, much better exercise is to understand the uniqueness of your family situation and what’s going on and really dive in and fully understand those decisions that you have that are coming up and making sure that you really maximize those decisions for your situation is a little bit better exercise or approach leading into retirement or even into retirement than just saying, “Hey, I need to hit a mill or I need to hit 1.5 million and then I can pull the trigger.” So I want to go into a few of those decision points that I think a lot of us will have as we approach retirement and how we can maximize them and put ourselves in the best foot going forward.
Walter Storholt:
Okay. What’s the first one we should dive into?
Tyler Emrick:
Good old social security wall.
Walter Storholt:
All right, excellent.
Tyler Emrick:
So maximizing that decision, and I do think that the narrative around social security has changed fairly substantially over the years, and the general concept for social security is, “Hey, you can take it as early as age 62.” There are some benefits that you can actually get at age 60, like a survivor benefit or a widow’s benefit, but age 62 for the vast majority of us is going to be that first year that you can kick in, and then you can also delay benefits all the way up to age 70. So you have this pretty large window from essentially 62 to 70 to make a decision on, “Well, hey, when do you start it?” And that decision is going to have very big repercussions over your retirement plan and the aggregate for the entirety of your retirement. And we look back over the data, social security is very forthcoming on claiming data and what trends are happening with Social Security.
So if we look back over 2022 and we look back over what the Social Security Administration says on the claiming age and the average benefit that you receive on those claiming ages. So let me say that another way. Essentially all I’m doing is I’m looking at a chart that starts at age 62 and goes all the way to 70, and then it gives me the average benefit in 2022 of individuals that were that age and what they got. For example, the average individual that was age 62 that actually started taking benefits and claiming it, their benefit was just under 1,300 bucks a month. If we compare that to individuals that were age 67 and just starting their benefit, their average benefit was about 2,400 bucks a month. So that’s a pretty substantial increase. I think that’s what almost a 50% reduction by taking it at 62 versus 67 in the average benefit, if my math is right there, Walt.
Walter Storholt:
Yeah, I mean, that’s a huge difference. I mean, we’re talking a mortgage is worth a difference in some cases, you know what I mean?
Tyler Emrick:
Absolutely. Well, and you’ve got to be careful because, of course, there’s a lot of nuance baked into these numbers. All they’re doing is taking the average benefit for the person that’s aged 62 and 67 that took benefits that year. Some very astute listeners might be going and saying, “Well, if I take my benefit at 62, I’m not going to get a 50% reduction in benefits.” And that’s true. The reduction for taking it at 62 versus your full retirement age is somewhere in the order of around 30% of a reduction. So what’s baked into this data is some nuance, and what that tells me is that yes, individuals are taking a bit of a haircut, but it’s essentially saying, “Hey, individuals that have smaller benefits that have maybe paid in a little bit less into social security are the overwhelming majority, or not the overwhelming majority, but are skewed to starting their benefits a little bit earlier.”
So there might be some claiming strategies that are driving this data, I guess is what I’m getting at. Because if you look at two spouses, generally speaking, it’s going to be very beneficial for the higher income earning spouse to delay benefits and maybe the lower income earning spouse to start benefits early. So we’re seeing some of that reflecting into this data with the average benefit at age 62, almost 50% lower than what individuals age 67 are getting. Now, of course, if you look at the data and say, “Well, what are the average benefit for someone that waits till age 70?” Now you’re looking at a pretty standard increase, which we would expect of about 8% per year. So the benefit jumps from 2,400 bucks a month at age 67 and goes up to just under $3,100 a month if you waited till age 70. So throwing a lot of numbers out there, but you kind of look at that swing, it’s average benefit of a 62-year-old, about 1,300 bucks a month. Average benefit for a 70-year-old was about $3,100 a month.
So there’s a lot of play in there and certainly some benefits there to wait depending on your family’s financial situation. And I made a comment as I was kind of diving into social security that I thought that the narrative was changing, and I think that’s pretty clear in the data. If we go back to 1998, the weighted average age that individuals claimed benefits was 63 and a half years old. Now it’s about 65. So it’s a clear trend where individuals are waiting longer and the words are …
I think the data and the education is getting out of there to way people are making a little bit better decisions for themselves. But maximizing that social security I feel like is a very integral part of what a lot of families are going to have to do and will weigh heavily on success rates and what your overall financial picture is going to look like, especially as you kind of zoom out and you maybe look 20, 25, 30 years down the road in those later years of retirement and actually looking at the difference in payments in social security versus what you’re going to get earlier in retirement. It definitely compounds and adds a pretty substantial benefit to the plan.
Walter Storholt:
It makes it clear why it’s so important to get that decision right, just because it can move the needle a lot depending on the rest of your financial situation and what’s going to make the most sense for you when it comes to electing social security. And I think putting it under this lens is really helpful, Tyler, to just kind of see those inner workings and see the big difference that it indeed makes when you get that choice right in the context of the rest of your plan. So that’s helpful.
Tyler Emrick:
Yeah. I’m going to kind of shift gears a little bit and talk a little bit about portfolio construction and kind of how you can look at your investment makeup of the accounts that you have, whether it’s a 401K, IRA, investment account or whatever the case may be. And I really want to focus on this idea of diversification. The old adage is the only free lunch and investing is diversification. And essentially, the reason for that is by combining uncorrelated investments, wealth compounds more consistently and smooths out your ride, and investors can achieve their financial plans with greater certainty.
So I think diversification is extremely important. You look back through the data over the years going back to the 1920s, there’s a clear benefit to not having all your eggs in one basket, but in actuality at time and time again, I have families that come in the first time I meet with them and I’m talking through their investment allocation and how their investments are broken up now, and they’re not nearly as diversified as what they maybe think it is. And I think there’s a lot of contributing factors to that, but frankly, Walt, I think it’s really hard to take some of that emotion out of investing.
So I want to go through some of the common pitfalls and some of the things that we feel are very, very important as you’re looking at that overall portfolio construction that truly move the needle and can really add value to an overall retirement plan. But at the end of the day, those investment decision, it’s hard not to get caught up into it. I mean, shoot, Walt, as I think about just our investing process, that’s why we have our process put in place because we are trying to take that emotion out of managing a portfolio and not trying to get so caught up into headlines, but using data to make informed decisions on investment changes and the like.
Walter Storholt:
Well, you’re very timely with this, Tyler. I know this won’t release moments after we tape it. It’s going to be two days later, but as we are talking, the whole GameStop thing is blowing up again, right? The meme stocks. So talk about emotions and people wanting to jump in and ride the wave and getting all caught up and all that excitement. Anybody who has followed those pieces of news back from, what was that? 2021 when that last …
Tyler Emrick:
It was kind of going by the meme stock craze, I think it was in the early 2021 and the individual-
Walter Storholt:
[inaudible 00:22:05].
Tyler Emrick:
I’m going to laugh. His name. What is it? Roaring Kitty, I think is his tag.
Walter Storholt:
Something like that. Yeah, Roaring Kitty.
Tyler Emrick:
It’s amazing how communication and that can actually drive a certain stock performance. And not only is there sometimes not any logic behind it, but it’s actually very counterintuitive, which is kind of coming up in the situation with GameStop if anybody’s familiar. But no, you’re absolutely right.
Walter Storholt:
You talked about emotions and that automatically got my brain like, “Oh yeah, I’ve seen that play out literally today as we talked.
Tyler Emrick:
You got it. But as we kind of think about that when we look at diversification, I think the first lens that I want to look at it through is just your overall asset allocation. And individuals can kind of think of that as just the amount of money that you have in stocks and bonds. And that overall makeup and mix is going to have lasting effects over how your account changes over time and the overall return that you can expect. Stocks have historically outperformed bonds. We call that the equity risk premium. You get paid for taking on that stock risk and sometimes … not sometimes, frequently I’m having conversations on why would we want to invest in anything else but stocks, especially coming off a year like 2023 where the stock market has had very substantial performance and outsized gains, especially over its historical averages. A lot of times what happens is families’ portfolios can become more and more stock-heavy as those stocks outperform.
And the risk that we really got to be careful of, which is one we’ve talked about on the podcast many a times, that sequence of return risk, which is essentially if you think about, “Hey, you head into retirement and you experience a market downturn like a 2008, for example, where we had the great financial crisis and you see your accounts drop by a very, very substantial amount for an extended period of time, and all the while you might be drawing off of that portfolio.” It’s almost a double whammy where hey, your accounts are down, but then you’re also pulling from investments that are down. So you think about your overall situation and say, “Hey, why would I not want to invest all my money in stocks? There’s been a clear outperformance over the years.” Well, that sequence of return risk, and if you’re using that money and having to sell out when those stocks are down, that can have a pretty negative impact on your overall plan.
It’s actually something that we test against with all our plans when we go through and update them on a year in year out basis is trying to test portfolios to give families an idea, “Hey, are you getting too aggressive? Are you in a situation where you’re at risk of having to change your spending patterns if the stock market were to have a pretty sizable tick down?” So we really want to be mindful of that overall asset allocation, but then if we can kind of look at it and take one step down and granularity well within, say, your stock allocation for example, or your bond allocation, what we found is you can be very diversified in that particular category in itself, especially here as of late. If you look at something like the S&P 500, which is a representation of mainly US, well, US companies, the 500 largest, and you look back over 10-year annualized returns at the S&P 500, we’re looking at about a 12% return per year.
And if we compare that to like the MSCI, a World X US index, which is essentially everybody else but the US, it’s coming in at average in just under 5% return per year. So that’s a pretty substantial difference from return. You’ve gotten paid quite a bit for taking on exposure in US companies over the last 10 years, and that’s a pretty wide margin. I mean, what? That’s almost like an 8% delta there, Walt. So over time, what has happened is families’ portfolios have become more and more and more overweight in US companies, and I think that’s a fact of just what’s happened over the last 10 years. But what we always want to make sure that we’re taking an expanded approach when we’re looking at the investments and not using just a small-time period like the last 10 years to make our investment decisions.
I mean, if we go back just to the prior year decade from roughly 2000 to 2010, a lot of us refer to that as the lost decade where stock performance across the US was practically nothing and a little bit negative. So you got to be mindful of these extended periods of outperformance and just make sure that you don’t get your hand caught in that cookie jar and saying, well, “Hey, why am I having any other exposure out there? Why do I want to be in international companies? Why do I want to be in the emerging markets? I should just have all my money in the US. That’s been the winner here more recently.”
And I think that’s a really risky approach and over time is not going to give you what we would consider to be the most optimal return or highest expected return from the portfolio in the long run. I mean, it’s even more sizable here, Walt, within the last year where I feel like AI and tech headlines have really driven the show and there’s been a subset of a handful or a couple handfuls of companies that have really driven some of the performance here as of late. And when you get down into the nitty-gritty, the question becomes is do you want a lot of your return or a vast majority of return just to come from a handful of companies? And I would argue that that can get you in a little bit of trouble.
Walter Storholt:
Yeah, I mean, that can be concerning when you think maybe the whole market is doing what you were hoping it was doing when really it’s just being driven by a handful of companies. And so are things really as strong as they seem and all of that kind of stuff, I think is hard maybe for the average investor to understand all of those nuances that can be a difficult part of investing and saving.
Tyler Emrick:
Yeah, well, anytime you’re looking a little different than you have the water cooler talk, you’re talking to a buddy or a friend and they’re talking about all their wins as they always do from a performance standpoint, right? “Hey, my account’s up like this, my account’s up there.” It’s really hard to not get caught up into what’s going on and just making sure that you’re making non-biased, non-emotional decisions around the portfolio. And I think now more than ever, it’s going to become increasingly important. And certainly, if you look back through the data going back to the 1920s, it’s proven to be a winning recipe to be diversified and taking that more deliberate approach and not necessarily getting caught up into what the latest hot trend is.
Walter Storholt:
Good point. All right.
Tyler Emrick:
Yep. So we’ve talked a little bit about overall asset allocation and how that can be important and how that can really set you off on the right foot as you kind of head into retirement, especially avoiding that sequence of return risk or at least understanding how that could affect your retirement. And then we talked a little bit about diversification within stocks is the example we use, but the same concept works over into bonds. I’d like to take it even one step further and maybe get even a little bit more granular. You kind of take a look at our portfolios and how we break them down. We actually have three asset classes from a high-level view that we tried to represent and benchmark against, and your traditional stocks and bonds make up two of those. But we do have a third category called diversifying assets.
In the industry, those types of investments can be anything from alternate investments, and diversifying assets, there’s a host of names that can be used for them, but when we start looking at overall diversification and the benefits of diversification, these alternative investments are again what we call them diversified assets. Their goal when we add them into a portfolio is to smooth out that ride and increase expected returns. So really said another way, we’re looking to add investments to the portfolio that are uncorrelated or lowly correlated with one another.
Now there are varying degrees of correlation. Again, when I say correlation, I’m just meaning, hey, how investments move together. And the idea is by adding investments to the portfolio that may be zig when everything else zags is added value over time. And again, anytime we could add value, increase diversification, and increase expected return, that’s a good thing. I always used to say, if you like every investment in your portfolio and all of them are performing exactly the same, well, then you’re probably under-diversified inside that portfolio and everything will probably go down just as fast together.
And that’s really what we’re getting at is being deliberate and being thoughtful about what gets added to the portfolio and what’s its use case in the portfolio and really getting it down into the why is that being held inside of the portfolio. You look back through data, JP Morgan puts out what we call the guide to the markets. It’s a slide deck. It’s very informative and very helpful. They actually used to have a slide, I think they took it off here within the last year, but really got down into, well, what is the value or the benefit of adding these alternative investments to the portfolio and what does that do to the risk and return trade-off to a varying or a similarly profiled stock bond portfolio. And really across the board, I think they looked back through data going back to the late 1980s and I think the data was through the end of 2022.
And essentially when they looked at that, they said, “In every portfolio that we looked at, if we add in a sleeve of these alternative investments, it did two things. It lowered annualized volatility.” So that’s another fancy term for just saying, “Hey, it lowered overall risk of the portfolio.” And it increased returns of the portfolio over the time periods that they looked at. So anytime you look at doing those two things, I mean, that’s what we’re looking to do from a portfolio construction standpoint, it’s something that we want to be mindful of. Now when we start talking about non-traditional or alternative investments, we do need to be very mindful because these types of investments can have higher fees. They certainly can add complexity to the portfolio and the underlying structure of the investment vehicle that we use and the objective that they’re trying to accomplish is extremely important.
So for example, we’ll go down into one of them. When we look at adding alternative investments to a portfolio, you’re going to have to take investments from somewhere else. So right, you’re going to have to take money from stocks or money from bonds to make that investment into alternative investments. And at times, that can add to quite a bit and pretty substantial performance drag on the portfolio where you might be asking yourself, why is this added to the portfolio? I could have just had that money in stocks and I would’ve been better off. Now what happens is, is when you look at the underlying construction of some of these investments, they understand that that can be a hard decision. So what they do is they have an idea called return stacking. What that means is, at its core, it’s just the idea of layering one investment return on top of another.
So achieving more than a dollar of exposure for each dollar invested. This is not a new story. I mean, you can go all the way back to the ’80s at PIMCO, which is why we’ve had their funds in our portfolio in the past. They’re a wonderful company. I’m sure many of the listeners have heard of PIMCO before. Certainly, our clients have. They decided rather than searching for alpha and large cap equities where competition was fierce, they would actually buy passive equity exposure and look for alpha in short-term, high quality bonds where they felt that they had an edge. Is it the alpha?
Walter Storholt:
I’m sorry, Tyler, I just had to hit you there because you said PIMCO, alpha, large cap equities, passive equity exposure all in one sentence. So it was an accumulation.
Tyler Emrick:
That was a little bit of a doozy, wasn’t it?
Walter Storholt:
It was an accumulation. That’s what it was.
Tyler Emrick:
Yeah, no, fair enough. Fair enough. I’ll dive in and explain alpha here in a second. But yeah, no, there’s certainly some buzzwords in there. But to really make that idea work, PIMCO would gain its equity exposure through capital efficient derivatives such as like futures swaps. So I could have probably done the egg ahead alert after that one too, right?
Walter Storholt:
Yeah, no kidding.
Tyler Emrick:
But really what this meant is that they only had to outlay a fraction of their capital to achieve the passive of equity exposure, leaving the remainder of that capital available for investing in bonds. They wanted to, so they sort of solved that problem of having certain exposure inside the portfolio and did it in a creative way, in a capital-efficient way to maintain return expectations. But then kind layer on top, i.e. return stacking, where they felt like they could add alpha to the portfolio. So over time, it allowed investors to separate beta from alpha. So what do I mean by alpha and beta? So beta is essentially how an investment moves against its benchmark. So the most popular beta as a beta of one. What that means is that your investment will act very similarly or perfectly correlated to the market overall. So if stocks go up, your investment goes up, your return and your investment can come from, that’s called beta. Alpha is basically the return that you get above and beyond the benchmark, right?
Very, very hard to get alpha. Everyone’s seeking alpha, right? Alpha’s term is thrown out there quite a bit, but that is the added benefit of doing whatever you’re doing. So that’s outsized returns over the benchmark, right? So these investments, when you’re able to separate out those two risks and two returns, what we’re able to do is be very clear on the why an investment like this would be added to the portfolio. So this concept became known as Portable Alpha if you’ve researched it or came across any articles online.
Now, the benefit of this is investors can introduce diversifying assets and strategies without sacrificing exposure to traditional asset allocation like we mentioned before. And at the end of the day, what we’re trying to do is enhance diversification and expected returns. So I got really, really granular there with some of the fund structure, but I figured it would give a little bit of insight into the level of detail that should be going down into the underlying investments that make up your portfolio. And we don’t take these decisions lightly here at True Wealth Design, and we’re analyzing and trying to make sure that when we add an investment like this, there is a why behind it, and our advisors can speak to that and understand it. And really at the end of the day, what we’re trying to do is provide better outcomes for our families.
So as we’re kind of wrapping up here, Walt, I mean, I think the big thing as we think about today is, hey, if you hear someone or if you’re trying to shoot for some type of magic retirement, number one, you need to know that what is your magic retirement number and what are you using that number to make decisions off of? And two, hopefully, we got some ideas on where families and individuals can start really maximizing retirement planning decisions and really start adding into and adding value and saying, “Hey, if I make the right decision around social security, hey, if I avoid some of these pitfalls with my portfolio construction, all that’s going to do is set you up and make you more efficient heading into and throughout retirement.” And hopefully, in our mind, all that work will pay off and provide better outcomes as I mentioned before.
Walter Storholt:
Oh, it’s fantastic, Tyler. Love this level of detail, even if I admittedly don’t understand all of it through a first listen. Tyler, we’ve heard from listeners before that sometimes they’ll listen to your episodes a couple of times to get some of these deeper conversations, but they’re conversations that aren’t being had on every financial podcast out there or that every advisor out there isn’t even going into this depth or wouldn’t even have this level of knowledge.
So it’s cool to know that this is the kind of thinking, the kind of thought process, the kind of research that’s going into portfolios and the decision-making that you and the rest of the team at True Wealth Design are building and constructing inside of portfolios and taking into account with your clients. I think that’s very cool. So I appreciate this level of detail. If you would like to learn a little bit more about not just this, but other planning strategies that True Wealth Design uses and to see if you’d be a great fit to work with an experienced advisor on the True Wealth Team, all you have to do is go to TrueWealthDesign.com, click the Are We Right for You Button, and you can schedule a 15-minute introductory call with an experienced advisor.
Again, just go to TrueWealthDesign.com and click the Are We Right For You Button. You can also call 855 TWD PLAN and chat over the phone for your initial call as well, 855 TWD PLAN. All that contact information is in the description of today’s show, so you can find it very easily. Tyler, great job today. Really appreciate the insight and perspective, my friend, and have a great couple of weeks and we’ll look forward to talking to you soon.
Tyler Emrick:
Will do. We’ll catch you on the next one.
Walter Storholt:
Go enjoy some Applebee’s.
Tyler Emrick:
Will do.
Walter Storholt:
Or McAlister’s. Your pick.
Tyler Emrick:
Yeah, that’s right. McAlister’s, much more preferred.
Walter Storholt:
Good stuff. Thanks for joining us, everybody. We’ll see you next time right back here on Retire Smarter.
Speaker 3:
Information provided is for informational purposes only and does not constitute investment tax or legal advice. Information is obtained from sources that are deemed to be reliable, but their accurateness and completeness cannot be guaranteed. All performance reference is historical and not an indication of future results. Benchmark indices are hypothetical and do not include any investment fees.
