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TDFs Can Help Investors Wade Through Choppy Markets

Written by Paul Bosse, CFA

Rising market volatility has recently caused some investors to run for cover. In an effort to outrun the market’s ups and downs, many investors will take action such as selling stocks and buying something else. But what else is there? Bonds are the other big asset class, and they also seem expensive from a historical perspective. Cash yields remain low at the time of this writing. So what are some options for investors who are convinced volatility offers opportunity? They could:

  • Sell their stocks and go to cash to reinvest after the market correction.
  • Buy shorter-maturity bonds to avoid big losses as interest rates rise.
  • Buy low-volatility or high-dividend stocks that may lose less in a correction.
  • Acknowledge they’re not good market-timers and adhere to a more disciplined approach.

This last choice is where Vanguard Target Retirement Funds might help. But before discussing target-date funds (TDFs), let’s look at the ways investors often try to escape turbulence and how their actions can backfire.

Strategy 1: “I’ll sell my stocks and buy them back later after the price drops.”

This is called market-timing and most investors are terrible at it. Financial professionals aren’t good at it either. A study of products that specialized in market-timing showed that, on average, these funds trailed their benchmark by 3% a year.¹

Strategy 2: “I’ll shorten my bond maturity.”

This is another common approach. If rates rise, shortening bond maturities is a plus. But if rates hold steady or go down—which often happens when the stock market falls—investors lose. Shortening bond maturity also means forfeiting the higher coupon of longer bonds and their stabilizing role on equity assets. The chart shows that when stocks do poorly, the only asset that does well are high-quality bonds. But it’s important to consider the right bonds for the portfolio, not just for the yield.Vanguard


Strategy 3: “I’ll buy low-volatility and/or high-dividend stocks.”

This may work, although by definition a “low beta” passive portfolio also has a lower long-term return than the broad market. Another issue is that these strategies have become so popular that valuations have risen. Many of these stocks are also interest rate-sensitive, so this is not an optimal approach if rising rates are a concern. Finally, following this model means buying a more concentrated position in utilities, old-time manufacturing, and banks. Less diverse portfolios are not typically ideal.

Planning for periods of volatility

This all brings us to the humble view that a special talent for timing the markets is rare. And you realize that being wrong can have a pretty stiff opportunity cost. Below we see how missing just the ten best days in the market can turn an investor’s equity return into a cash-like return. Missing the 20 best days can yield a negative return. Plus, these “best days” are intertwined with “worst days,” which makes timing even tougher (8 of the 10 best days were during the Great Recession of 2008 and 2009).

Missing the best performance daysVanguard

Sources: Reuters, Vanguard calculations.

The usual methods of controlling risk can still work. Diversification across asset classes and geography begets lower volatility than a concentrated portfolio. Keeping costs low always helps, especially in the low-return environment we have today. Finally, portfolio discipline is fundamental to achieving good results in volatile markets. That means not chasing performance winners, not panicking during market corrections, and rebalancing the portfolio regularly to maintain the risk profile designed to meet the investor’s long-term goals. And in volatile markets, rebalancing can add significant portfolio value.

Well-designed target-date funds (TDFs) can provide the appropriate levels of equities and appropriate bonds for each point in an investor’s life. Importantly, these portfolios have built-in discipline—they rebalance automatically, returning the portfolio to the prescribed risk and return levels set before the emotionally trying times of a market correction.

Participants invested in a 401(k) should know that their target-date investments are designed to remain “on target” during inevitable times of market volatility. Plan sponsors may want to remind their membership that their assets have the mechanisms that can help their portfolios withstand the challenges of market volatility and stay aligned with the goals they set for achieving investment success.

To learn about Vanguard Target Retirement Funds, contact your Vanguard representative or visit Target Retirement Funds on our website.

¹ Tactical allocation funds (as defined by Morningstar) were used in the analysis; a total of 23 funds with 120 months of data were evaluated, from a time period of January 31, 2007, to December 31, 2016. Sources: Vanguard calculations, using Morningstar, Inc. data.

About the author: Paul Bosse, CFA, is a principal with Vanguard Investment Strategy Group, where he consults with institutional clients on asset allocation and portfolio construction. Before joining Vanguard in 2006, Mr. Bosse was director of asset allocation and chairman of the investment committee at DuPont Capital Management where he designed the strategic asset allocation for the pension trust fund and managed the global tactical asset allocation portfolio. He also had investment oversight for several international pension plans.

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Notes:

  • For more information about Vanguard funds, visit institutional.vanguard.com or call 800-523-7064 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

  • All investing is subject to risk, including the possible loss of the money you invest.
  • Diversification does not ensure a profit or protect against a loss.
  • Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
  • Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.
  • Investments in Target Retirement Funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in a Target Retirement Fund is not guaranteed at any time, including on or after the target date.

© 2018 The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor.


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