Testing the Target-Date Theory

A 113-year data from 20 countries shows longer is safer when it comes to equities.

(September 11, 2013) — Duration has functioned as a diversifying factor for portfolios throughout modern market history, according to a study on optimal long-run asset management.

The analysis, “Optimal Portfolios for the Long Run,” written by David Blanchett of Mornigstar, Michael Finke of Texas Tech University, and Wade Pfau from the American College, examined over 113 years of data covering equities markets in 20 countries.

Their findings suggested that investors in target-date funds and pension funds could expect to benefit from lower risks when investing over the long term in equities.

Consistent with previous studies by Campbell and Viceira (2003) and Estrada (2013), the study found that stocks steadily outperformed bonds internationally over longer holding periods, but added that the level of said outperformance is varied.

Using a constant relative risk aversion utility function with variables in risk levels and investment time periods, the research concluded that average optimal equity allocation increased over longer periods—from 1.3% per year for highly risk tolerant investors to 2.7% per year for the extremely rise-averse.

This finding suggested that stocks should become more appealing to risk-averse investors over longer periods.

The authors also found that while the results of US portfolios were largely consistent with those of most other countries in the study, Australia and Switzerland stood out from the average.

Australian markets returned the highest equity risk premium (ERP) over bonds at an average 5.6% between the years 1900 and 2012. At the other end of the spectrum, Swiss equity markets added just 1.99%.

When analyzed for smaller time periods, the research determined that optimal equity allocations for shorter-term investors have been decreasing while the benefits of time diversification have increased over time.

In essence, the authors argued investors would experience advantages of time diversification unless the ERP dips below zero or stocks underperform bonds, on average, by 0.7% per year.

Read the full paper here.

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