In the paper "The impact of staying invested during market turmoil", Russell Investments presents some data demonstrating the consequences of several different courses of action during the 2008 financial downturn, through the end of 2010.

The data shows what would have happened if a hypothetical investor had a $100,000 portfolio, and had invested 60% of the portfolio in a broad index of stocks and 40% in a broad bond index on October 9, 2007, and then took one of three steps on September 30, 2008.  The initial date - October 9, 2007 - was the height of the market prior to the downturn.  September 30 was about two weeks after the Lehman Brothers bankruptcy, and was a point of inflection that marked the front end of the most significant market drop during the downturn.

It's also worth noting that a 60/40 portfolio is a reasonable representation, but it isn't an optimized portfolio for most investors.

The Courses of Action and Results

Course 1 -  Stay the course and maintain the 60/40 index strategy through the end of 2010.  This would have yielded a portfolio value of $104,502.

Course 2 -  Pull out of the market altogether on September 30, 2008, going to 100% cash, as represented by a short-term Treasury Bill Index.  This was a typical (and understandable) fear-based move that was not at all uncommon during that time period.  Doing so would have allowed the investor to miss the worst of the downturn.  It also would have resulted in a portfolio value of $85,469 on December 31, 2010.

Course 3 -  Pull out of the market altogether on September 30, 2008, and invest 100% in a broader Treasury index.  This is another fear-based, defensive move that probably makes more sense than going to all cash, but likely wasn't quite as common.  In this case, the investor would also have missed the most severe segment of the downturn.  This portfolio would have ended 2010 valued at $94,451.

The Bottom Line 

Clearly, staying the course in this case would have had a significantly more positive impact on continued wealth-building than taking other, more fear-based actions.  The years in question represent a small sample size, but also a very extreme example of the bottom falling out of the market.  Furthermore, investors with a deliberate strategy optimized for their level of risk tolerance generally would have done better than what the paper demonstrates.

Of course, what the paper doesn't show is the mental anguish associated with holding on when the world seems to be caving in around you.  This is especially tough when you have no idea where the market is going at any point in time.  The fact is, nobody knows what the market will do tomorrow, but we do know what it has done over long periods of time.  Hopefully this data will help to provide some context for how to approach the next market downturn.

An oft-cited tenet of investing philosophy that has been passed down over the years is that Dollar Cost Averaging (DCA) is a good way to invest in a risk-managed manner, particularly for beginning investors.

The basic approach is that you invest a consistent amount at regular intervals, which ensures that you buy more shares when prices are low (and fewer shares when they're higher).  You engage in DCA with each 401(k) contribution, and with any systematic investments you make to an IRA, 529 plan or a taxable investment account.

For instance, if you had $8,000 to invest at the beginning of this year, and decided that you simply wanted to invest in an index fund that tracks the S&P 500 Index, you could have chosen the SPDR S&P 500 Exchange-Traded Fund (SPY)*.  You would have then faced the decision of when to invest the money.  Doing so on January 1 would have allowed you to buy at $128.68.  Investing $1,000 on the first day of every month would have given you an average cost of $131.16, because prices trended higher through much of the first half of this year. 

Is it a good idea?

Probably the most logical comparison to make is between DCA and lump sum investing.  In other words, if you don't have a lump sum that you could invest at the beginning of a period, but want to invest on an ongoing basis, your decision to dollar cost average is pretty straightforward.

What if you do have a lump sum that you could invest?  Should you average into the market over time?

While DCA may feel better to a lot of investors, the fact is that it doesn't result in better aggregate returns.  If you had $10,000 ready to invest at most points in history, you'd be statistically better off putting it all in the market rather than averaging in over time.  Why?  Because the market typically goes up.  I know, I know, it doesn't seem like it, especially after watching CNBC the past few weeks.  However, between 1970 and 2010 most sectors within the stock market showed a loss in only 7-9 of the 40 years, depending on the sector.  Since 1926, it's more like 20 years, out of 84.  I don't want to sound too analytical, but the stock market goes up more than it goes down.  It stands to reason that investing a lump sum at the beginning of a period will generally do better than spreading it across a series of investments over a number of years.  Of course, you may not want to break that data out at a cocktail party with somebody who went all-in in May of 2008.

The decision to invest the lump sum is more obvious for the dividend enthusiasts among us.  Waiting to get into the market could mean foregoing dividend payments.  Those dividend payments can be reinvested, and over the long run they will contribute significantly to the overall returns of a stock market investment.

Does it ever make sense?

A Dollar Cost Averaging approach to investing matches up nicely with most savers' ability to invest.  Not many of us have a pile of cash sitting around looking for something to do.  Not to sound like Yogi Berra, but if such a pile exists, and we invest it, it no longer exists.  Systematic investing makes a ton of sense, and that implies that DCA is at work.  The discipline and forced savings that accompany such an approach are key components of building wealth, and in that sense Dollar Cost Averaging makes a ton of sense.

*Not a recommendation to buy a specific security.

If you participate in a 401(k) plan, chances are you've heard of target-date funds.  Perhaps you've even been told that your contributions will default to such a fund if you don't specify otherwise.  In the last few weeks I've worked with employees of at least 4 employers for which this is the case.  All in all, more than 70% of 401(k) plans now offer target-date funds, and for various reasons they are often the default option for new participants in the plans.  Another popular use of these funds is in 529 plans for college savings.

So...what is a target-date fund?

A target-date fund is a mutual fund that invests in multiple asset classes in a way that is designed to be appropriate for a time horizon defined by the fund.  The asset mix changes to become more conservative over time, as the target date gets closer.  This change in asset mix over time is commonly referred to as the glide path.  Because it invests in multiple asset classes, such as various classes of stocks and bonds, and alters the asset allocation over time, the target-date fund is really designed to be a portfolio unto itself.  In practice, such funds will typically invest in several other mutual funds, each of which is dedicated to a specific asset class.

Challenges of target-date funds

Probably the most significant over-riding challenge associated with target-date funds is the fact that many consumers group all such funds together.  I think most tend to understand the difference between a fund targeted at, for instance, retirement in 2015 vs. retirement in 2040, fewer seem to distinguish between the 2040 offering from Vanguard and the 2040 offering from T. Rowe Price or Fidelity.  These funds are not necessarily managed in a similar manner.  Asset allocations will likely differ, and the underlying funds that the target-date funds own will certainly be different.  A recent Government Accountability Office (GAO) report found that the performance of these funds varies widely from family to family.

More specific criticisms include:

Expenses - Target-date funds typically charge fees at the fund level, including a management fee to cover the effort associated with defining the asset mix and selecting underlying funds in which to invest.  Of course, these underlying funds charge fees of their own, which results in the layering of fees.  The underlying funds are often index funds, and the associated fees can be relatively inexpensive.  That's not always the case, though, and it takes some digging to unearth the total cost of investing in target-date funds.

One-size-fits-all approach - The fact that two individuals plan to retire in the same year does not mean that an identical investment approach is warranted.  Among other things, they may be different ages, and may have different levels of risk tolerance.

Investments - The fund family that manages a target-date fund will typically look to invest in funds from within the same family.  For instance, Fidelity will invest in Fidelity-managed funds, the MFS Lifetime funds invest in other MFS-managed funds, etc.  Without trying to indict a specific fund family, there may be an incentive to use less popular and less successful funds within the target-date funds.

Are they good for anything?

I think the best argument in favor of target-date funds is that the better ones serve as a reasonable default option for investors who will not otherwise put forth the effort to select funds in a methodical manner, according to an allocation that makes sense for them.  If they prompt people to save who otherwise wouldn't, regardless of the reasons, they are probably serving a valuable purpose.  Regardless, this is an increasingly broad category of products, and to really ensure that a target-date fund is a reasonable option requires some digging.  

Reminder for Intel employees: this week marks the deadline to elect changes to your investments and contributions related to Intel's overhaul of your 401k plan.

If you're a participant in the Intel 401k plan and don't make an election by Friday, September 9, your existing funds and future contributions will default to a target-date fund that corresponds to your date of birth. This shift will actually take place effective September 30.

The target-date approach may be a good option for you; regardless, it makes sense to review all of the options, ensure you've got complete information regarding expenses, and make a deliberate decision. Consider it an opportunity to put structured decision-making skills to work.

This is a big change. Some of the potential options will cost a lot more than they used to, and that will impact your returns. There have been so many options within the Intel 401k that the impact will be different for everybody. Several of the employees with whom I've spoken have been vaguely aware of a change, but haven't had an appreciation of its significance. If you're not sure what to do, feel free to drop me a line.