Should Younger Investors Take More Risks?

Last month, my esteemed colleague John Rekenthaler weighed in on the question of whether older investors have become too aggressive, based on research Vanguard conducted on retirement savers in the defined-contribution plans it record-keeps for.

To summarize, John took the view that, yes, some older investors are too aggressive. To be sure, the near-retirees that invest in their plan’s default option typically do just fine. But, as John points out in his piece, roughly half of older investors can’t resist the urge to tinker when left to their own devices.

On the flip side, Vanguard also found that younger investors largely don’t fall prey to the same temptation. More than 75% of investors under the age of 35 invest in a single target-date fund, which is generally considered the gold standard for retirement savings.

What Is a Target-Date Fund, and Why Do Young Investors Love Them?

A target-date fund is a multi-asset strategy that gradually shifts from stocks to bonds over the course of the investor’s life. Typically, people buy or are defaulted into one through their retirement or education saving plans and select the strategy that has a year that lines up with the year they expect to retire. Target-date funds’ key feature is a “glide path,” which describes how the investment adjusts the proportion of retirement savings that are allocated to different asset classes over time. As the riskier asset, stocks are the primary engine of an investor’s returns over the long run, so most target-date funds start with a generous helping of them before gliding to a much lower allocation later on.

Target-date funds have soared in popularity as the default option for automatic enrollment in defined-contribution plans, and to some extent, the uptick in adoption reflects plan sponsors steering younger investors into the vehicle. But a good chunk of them are opting into these strategies, too, which is a welcome development: Our research has found that target-date fund investors have tended to fare better than average, capturing more of the funds’ total returns when compared with other types of funds.

That said, Vanguard also found that the younger participants in its record-keeping plans were still investing only around 89% of their assets in stocks. That is pretty low, as the average longer-date target-date fund we track stakes around 93% in stocks, as shown in the chart below.

It appears that the average young investor in a Vanguard record-keeping plan is underweight stocks relative to the typical target-date fund. It’s a puzzling finding at first, but there are a few simple reasons why this could be.

The first is the dominance of the biggest target-date strategies, which are more conservative than the norm. (Morningstar does not take assets under management into account when defining the average target-date fund.) The two biggest target-date series—Vanguard itself and Fidelity—have glide paths that start with 90% in stocks, a notch more cautious than the average target-date series.

The other issue could be friction. Target-date managers can’t always invest all the way up to their desired strategic glide path—they need to keep some cash on hand to meet redemptions. Investors, too, may not be fully invested all the time. This is more of a problem for younger investors, whose contributions each month make up a significant portion of their overall balance.

Whatever the reason, it appears that younger investors are slightly more conservative in their retirement plans than they ought to be. The question is whether that’s a problem.

Could It Have an Effect on Younger Investors’ Retirement Savings?

The short answer appears to be no.

Target dates glide the way they do because they strike a balance between two sources of wealth: human capital and financial capital. Early on in their careers, young people may lack savings (that is, financial capital), but they boast future earnings potential (human capital).

The best way for someone early on in their career to improve their retirement outlook is by, in effect, converting their human capital into financial capital. They do so by socking away a portion of each paycheck. As time wears on and those savings compound, the picture changes, with financial capital approaching and eventually exceeding human capital.

What does that have to do with one’s stock allocation? It’s important to keep in mind that, until around age 35, contributions make up more than half of an investor’s overall balance, with investment returns making up the rest. Given that, modest changes in an investor’s asset allocation don’t make a very big difference.

An example might help to illustrate why this is so. Assume that stocks earn about 10% a year, while bonds print about 6%. If a young plan participant invested 5% more in stocks than they do in the average Vanguard target-date fund, they’d theoretically take home an extra 0.2% each year. So, let’s imagine it’s a 22-year-old investor who earns an average salary today and experiences the normal level of salary growth (broken out by gender, given the differences in growth and trajectory) over the course of their career. How would that participant’s ending balance vary if they began by allocating 89% to stocks versus 93%, contributed 10% of their take-home pay, and received a standard employer match?

When we run the numbers, we find that upping the stock allocation would add about $50,000 to that 22-year-old’s account balance by the time they retire. (All figures are nominal and assume a 4% inflation rate.)

But that pales when compared with the benefits the 22-year-old participant would reap by nudging her contribution rate a bit higher. For instance, if that investor chipped in 11% of their salary instead of 10% for the first 10 years of their career, it could add more than $300,000 to their ultimate balance.

In that sense, quibbling over the asset allocation kind of misses the point. For young investors, it’s contribution rate, and not the stock/bond mix, that really moves the needle when it comes to the size of one’s retirement nest egg.

On the Other Hand …

With a 40-year time horizon to play with, the consequences of a young investor sprinkling on some added risk are minimal. Investors are not as likely to make trades when they’re invested in a target-date fund and are less likely to yank money out when their investments start to slump.

Vanguard, of course, is aware of this. With respect to its target-date series, the firm argues that any risk above what’s absolutely necessary to deliver on investors’ retirement savings goals is unwise. Vanguard maintains a 10% exposure in bonds in order to temper volatility during downturns and favors higher contribution rates of 12%-15% to give investors the best chance of success. With contributions packing such a big punch, why court any more risk when stocks slide?

Still, it’s hard to argue against an extra dash of equity if you can stomach it. Like young investors, stocks have a great deal of potential: In the long run, they do deliver excess returns over bonds, all else equal. The road to get there might be bumpy, but every little bit counts. It may take lower fees, higher equity, or extra contributions for young investors to meet their ultimate retirement goal. Then again, it more than likely will take some combination of all three.