Monday, November 09, 2009
Target Date Funds
Recent experience (2008, 2009) has shown that target date funds have glide paths (stock/bond allocation over time) that turned out to have more equity exposure than people were comfortable with. People who were couple of years away from retirements, or had 529 with kids couple of years away from college, found themselves in target date funds with 60-70% equity exposure and lost 25-35% in 2008. Also, most target date funds have a high equity exposure in early years and many people may not be comfortable with putting in large lump sums when the equity exposure is that high.
One way to adjust the risk in a target fund is to combine it with a balanced fund. For example, a 529 target date fund for a baby may have a glide path of 90/10==>10/90 over 15-18 years. People may hessitate to put in a lump sum when the initial allocation is 90/10. Combining it with a moderate allocation (60/40) balanced fund in EQUAL amounts will result in an effective glide path of 75/25==>35/65. By having other appropriate ratios of target date fund and balanced fund, one can find a portfolio glide path that may be more comfortable.
One way to adjust the risk in a target fund is to combine it with a balanced fund. For example, a 529 target date fund for a baby may have a glide path of 90/10==>10/90 over 15-18 years. People may hessitate to put in a lump sum when the initial allocation is 90/10. Combining it with a moderate allocation (60/40) balanced fund in EQUAL amounts will result in an effective glide path of 75/25==>35/65. By having other appropriate ratios of target date fund and balanced fund, one can find a portfolio glide path that may be more comfortable.
# posted by yogiBB @ 3:26 PM 
Thursday, November 05, 2009
Was 2008 Really a Black Swan Event?
No! It was just a 2-3 STD_DEV (SD) year.
Under idealized assumptions (although that is not the market), with respect to averages:
+/- 1SD covers 68.26% of possible outcomes; so 15.87% of outcomes can be above +1SD and 15.87% of outcomes can be below -1SD (ie disaster once in 6.3 periods).
+/- 2SD covers 95.44% of possible outcomes; so 2.28% of outcomes can be above +2SD and 2.28% of outcomes can be below -2SD (ie disaster once in 43.86 periods).
+/- 3SD covers 99.73% of possible outcomes; so 0.135% of outcomes can be above +3SD and 0.135% of outcomes can be below -3SD (ie disaster once in 740.74 periods).
With moderate allocation balanced funds having SD of 10-14% annualized, a "-2SD event" could cause losses of 20-28% sometime in 43.86 years and that turned out to be 2008.
With conservative allocation balanced funds having SD of 7-10 annualized, a "-2SD event" could cause losses of 14-20% sometime in 43.86 years and that did happen in 2008.
So as painful as 2008 was, it wasn't totally beyond the realm of possibilities.
Lesson then is to control portfolio risk to one's comfort zone.
Under idealized assumptions (although that is not the market), with respect to averages:
+/- 1SD covers 68.26% of possible outcomes; so 15.87% of outcomes can be above +1SD and 15.87% of outcomes can be below -1SD (ie disaster once in 6.3 periods).
+/- 2SD covers 95.44% of possible outcomes; so 2.28% of outcomes can be above +2SD and 2.28% of outcomes can be below -2SD (ie disaster once in 43.86 periods).
+/- 3SD covers 99.73% of possible outcomes; so 0.135% of outcomes can be above +3SD and 0.135% of outcomes can be below -3SD (ie disaster once in 740.74 periods).
With moderate allocation balanced funds having SD of 10-14% annualized, a "-2SD event" could cause losses of 20-28% sometime in 43.86 years and that turned out to be 2008.
With conservative allocation balanced funds having SD of 7-10 annualized, a "-2SD event" could cause losses of 14-20% sometime in 43.86 years and that did happen in 2008.
So as painful as 2008 was, it wasn't totally beyond the realm of possibilities.
Lesson then is to control portfolio risk to one's comfort zone.
# posted by yogiBB @ 8:44 PM
