Out of Sight, But Not Out of Mind: Early Retirement Investment for Risk-Averse College Graduates

Introduction

During the financial crisis of 2008, many families watched in fear as their investment savings in common stocks and equity mutual funds plummeted. The Standard & Poor’s 500-Stock Index, an index composed of 500 companies which are representative of the US economy, saw its price fall by nearly 40% in 2008. With the future of the social security system uncertain, it is more important than ever for young generations to take personal responsibility for their retirement. Financial decisions made today can drastically impact college graduates’ financial futures, saving early and saving often are two of the most beneficial decisions an individual can make towards retirement. Young investors want to see their hard-earned money grow over the course of their lifetime. However, after having lived through the financial collapse of 2008 (and the dot-com bubble of 2001), it is reasonable for new investors to be skeptical of the stock market’s returns. Given the knowledge that many college students do not adequately understand basic concepts of investment risk and volatility, there appears to be a need to clarify these misconceptions (Chen 108).

My goal is to encourage potential college-age investors, who otherwise are reluctant to invest for their future in volatile markets, to begin saving and allowing their investments to grow. With US savings rates at all-time lows and the risk of Social Security reserves being exhausted by 2037, it is more important than ever for young individuals to take personal responsibility for their retirement as early as possible (Goss 112). For risk-averse, first-time investors, this means finding an investment strategy that is simple and easy to follow and allows for long term growth of principle regardless of short term volatility. The investment strategy that would most appeal to this group is a low-cost, diversified strategy that appreciates over the long-term. When determining the specific proportions of money invested in stock, bonds, and cash, I will use utility functions, consistent with statistical tests for validity, to measure the preferences of college-age investors with different levels of risk aversion.

Literature Review

There is endless debate about which investment strategies produce the highest and most consistent returns; most investors understand that increase in risk is correlated to an increase in expected return. The difficulty is in balancing the increase in expected return without substantially increasing the risk. Countless strategies have been developed to achieve this goal. One tactic is market timing, or trying to move into a market (buy) before prices increase and move out of a market (sell) before prices decrease. This might involve the use of quantitative values, or technical indicators, associated with a stock price. The 10 month simple moving average, the average of a stock’s closing price at the last trading day of the past 10 months, has been used as a technical indicator that influences where an investor should be invested in the market at the end of each month (Faber 23). Market timing tactics are often criticized for their inconsistency and tax-inefficiency. In Burton Malkiel’s A Random Walk Down Wall Street, he quips that no one has ever been able to time the market consistently by means other than luck (Malkiel 245). Aside from being more complicated and time consuming, market timing produces more frequent realization of capital gains (the profit from selling stock) which can increase one’s annual tax burden.

Buy-and-hold strategies are the simplest ways to introduce investors to long term potential for growth. Those who have a long investment horizon, or at least five years before invested money is needed, should allocate more of their assets in stocks (Barberis 251). This is because stocks tend to provide a higher return than bonds over longer time horizons, despite being more volatile in the short-term. Diversification, or owning many stocks rather than a select few, significantly can reduce the risk of a portfolio (Malkiel 72). Mutual funds and exchange traded funds (ETFs) are financial products that are effective at achieving this diversification in a single fund one can purchase.

Mutual funds and ETFs can buy part of a fund that contains shares of ownership in many different companies at once, so purchasing a mutual fund is similar to buying some stock from many companies. There are two types of mutual funds: actively managed funds and passively managed funds. Actively managed funds hire professionals to select and manage which stocks are held within the mutual fund’s portfolio. While, passively managed funds, also known as index funds, are managed so that the holdings in the fund are nearly identical to a market index, like the Standard & Poor’s 500 stock market index. Index funds cost less to manage and thereby tend to have lower expense ratios than actively managed funds. The expense ratio is the proportion of your investment that is charged by the fund company. These expenses can range from over 2% to as low as 0.05% in the case of the Vanguard S&P 500 ETF. To provide some perspective, a 1% expense ratio means that a fund will charge $100 in expenses each year for every $10,000 invested in that fund. The compounding of a high expense ratio and management fees over time will significantly reduce the potential return of an investment (Neuteld 61). Many investors are unaware of important considerations like cost and diversification when they first start investing.

College-aged students especially lack sufficient knowledge on financial literacy in general. A study in the Financial Services Review found that college students answered only about 53% of questions on basic personal finance correctly (Chen 107). Low levels of financial literacy can negatively impact individual decisions about personal finance and investing for retirement. Additionally, economists are overconfident that consumers will be able to make good decisions and stick to them, especially when it comes to retirement saving (Laibson 134). This is especially true for risk-averse investors who tend to avoid investments with high volatility and sell investments during periods of significant price decline. There are several socioeconomic factors, including age, sex, decision independence, and marital status, that appear to have a relationship with risk aversion (Baker 470). For example, women tend to invest more conservatively compared to men (Bajtelsmit 2). This is a potential issue as conservative investments earn less over the long term, on average, than more aggressive investments. However, there is sparse literature on specific investment strategies tailored to risk averse, young college students and graduates.

Much of this lack of literature can be explained by the inherent difficulty in measuring levels of risk aversion. Daniel Kahneman and Amos Tversky observed that risk averse behavior appears to stem from the phenomenon of loss aversion, where “a loss of $X is more aversive than a gain of $X is attractive,” (Kahneman 342). However, whether a situation is viewed as a potential loss or gain is heavily dependent on the framing of the question. Kahneman observed that it was possible to ask two groups to make a decision on effectively the same situation but elicit opposite results because of the question’s framing (343). This inconsistency in human perception is part of the difficulty in measuring risk aversion. Other economists have worked on solutions to this problem. This loss aversion implies mathematical structure on the values an individual applies to gains or losses. More specifically, a utility function would be concave for gains and convex for losses. David Harless and Colin Camerer attempted to mitigate the effect of these inconsistencies by creating a test statistic that allows one to judge the predictive validity of a given utility theory. With the data sets they have worked with, they created a set of possible theories to choose from that would provide the greatest improvement in fit (Harless 1251). Which theory works best is highly dependent on the types of gambles being made. Harless and Kahneman’s insights will help shed light in identifying the best-suited functional methods to represent the decisions of college-aged individuals.

Investment Prerequisites

Before exploring the optimal investment strategies for college graduates, their financial situation must be suitable for retirement investment. A young graduate could warrant potential for early retirement investing upon meeting the following conditions: 1) no high-interest debt, 2) sufficient emergency savings fund, and 3) expectation of consistent future income. While other factors, like student loan debt, deserve consideration, the three aforementioned factors must be met before one should consider an investment of any kind.

Consumer debt has been rising substantially over the past decade; it is now unsurprising for college students to graduate with some credit card debt. And this is separate from student loans, which averaged $20,800 for graduating North Carolina seniors in 2011 (Reed 6). It is crucial that graduates do not make the mistake of paying off their student loan debt before their credit card debt, as high interest debt from credit cards will grow much faster than federal student loans. The average variable credit card interest rate is over 15% while federal student loans are under 7% (Malkiel 277). At a consistent 15% annual interest, credit card debt will almost certainly grow faster than any type of investment. Depending on their financial situation, some college students may be charged a higher interest rate—up to 25% in some cases (Malkiel 278). Because of this, college graduates must be free from credit card debt before they consider investing for retirement.

A sense of financial security is another critical requirement for retirement saving. For college graduates who are employed, they should establish an emergency savings fund. This fund would ideally be several months of income in a cash savings account. In the case of an emergency, loss of a job, or a summer without income in the case of graduate students, college graduates could cover their living expenses temporarily without having to dip into their retirement savings. In order to replenish this fund, it is important that the individual works and expects a relatively consistent form of income. An individual simply cannot live independently without a sense of financial security. Retirement saving is meant to increase financial security in the future, not to burden one’s financial security now.

Once these pre-requisites have been met, a college graduate should begin to consider investing. But with a myriad of financial products on the market, where should they start? To narrow the choices, the investment strategies must follow certain criteria. Simplicity is a crucial factor, especially considering most college graduates will have limited investment knowledge. A study polled multiple colleges across the country and found that college students answered only about 53% of questions on basic personal finance correctly (Chen 122). With such low levels of basic financial literacy, the investment strategy will need to be simple and easy to follow. A Harvard study on self-control and saving for retirement asserted that economists are overly confident regarding the dedication and decision-making ability of consumers. David Laibson claimed economists overestimate the ability to make complex decisions (Laibson 92). Given that complex strategies are too complicated for average investors and that sticking to a plan can be difficult, the optimal strategy must be simple and automated. College graduates should decide on a straight forward plan that they understand and allows for consistent, periodic investments into that plan. If simple and automated, this strategy can save college graduates time and effort—an appealing caveat during a busy, transitional phase of their lives.

The decision to save for retirement requires long term considerations. Thus, investors must orient their strategies toward long term growth without regard to short term volatility, often referred to as a long term investment horizon. Investors can address this long term horizon in their asset allocation. Asset allocation is the relative proportion of money that is invested in each asset class like stocks, bonds, and cash. In the Journal of Finance, Nicholas Barberis analyzed the optimal asset allocation to stock in portfolios of long term investors with horizons of 10 years. He found that an optimal long term portfolio would be more heavily weighted in stocks (Barberis 254). This is because over longer time frames, stocks consistently outperform other asset classes. Stocks, albeit risky in the short term, appear less volatile for longer time horizons.

While investing in a single company’s stock is quite risky, an investor can reduce volatility by purchasing stock from many different companies. Diversification helps reduce the risk of holding a small number of stocks. For example, assume a graduate has all his savings in the stock of his employer; if the company were to go bankrupt, not only might he lose his job, but his investment savings would be decimated. Holding a large number of stocks reduces the effect of a single company on the entire portfolio. The financial industry has developed a type of investment, called a mutual fund, which offers this level of diversification. Many mutual funds are actively managed by professionals who pick the specific stocks in the fund. Other mutual funds are passively managed and are based off a market index, like the Standard and Poor’s 500-Stock Index. Passively managed funds do not actively pick out individual stocks, but rather align the fund’s holdings to mimic the index. When deciding between the two types, college graduates should avoid actively managed mutual funds. When compared to the S&P 500, few actively managed funds consistently outperform the index over long periods of time (Malkiel 168). Even if there are some actively managed funds that do well, past performance does not predict future results. Many active mutual funds that outperformed the market during the boom of the 1990’s experienced huge losses during the technology bubble collapse in 2000-2001 (172). Owning passively managed funds tied to broad market indices is the easiest way to expose graduates to diversified holdings.

All investible funds come with a cost; an expense ratio is a common measure of what it costs an investment company to manage a mutual fund. Actively managed mutual funds typically have higher expense ratios than passively managed mutual funds, these fees are deducted from an individual’s account and can reduce returns over time. If a mutual fund lags the S&P 500 by 2.5% annually, over the course of 10 years the investment company gets “46% of returns on average, leaving the investor with 54,” according to a study in the Journal of Financial Planning (Neuteld 62). To keep more of their hard-earned savings graduates will need to select passively managed funds with low expense ratios. This lower cost translates into more money retained in graduates retirements accounts – more money means higher potential for long term growth.

Young individuals should consider investing as soon as they have relative financial security. No high-interest debt, emergency savings funds, future income are minimum prerequisites. Once these criteria are met, young investors will be drawn toward retirement strategies that are simple to understand and implement. The need for simplicity encourages the use of diversified funds of many individual stocks, rather than the selection of individual securities. With a long-term horizon, the strategy should be more weighted in stocks and have low costs. Over time stocks have significantly outperformed other asset classes, despite periods of short term volatility. Regardless of portfolio performance, high expenses will significantly reduce the returns of personal investments over time. Thus, the optimal retirement strategy will be simple, diversified, low-cost, and long-term.

Investment Strategies

Now that the critical components of the ideal investment plan have been identified, we must match college graduates with the right financial products that meet their needs. Mutual funds and exchange traded funds (ETFs) are two types of investment products that can provide diversification at a low cost. Both products can be used as a way to passively index stock markets, however, while mutual funds can only be bought or sold at the end of the day, ETFs are traded on the stock exchange, weekdays from 9:30 p.m. to 4:00 a.m. Eastern Standard Time. Since the focus of the investment is long-term, the trading flexibility offered by ETFs is not a considerable benefit and may actually make restraining from trading during a downturn more difficult. Mutual funds typically will restrict sellers from buying back into the fund for a period of time (for Vanguard index funds this period is 3 months). With more limited trading options risk-averse graduates would be less likely to deviate from their long term plan. Another benefit of mutual funds is that they typically do not have transaction costs (Guedj 2). These are called no-load mutual funds and will often have options for establishing an automatic schedule to routinely invest into the fund. ETFs do incur transaction costs through most brokerage firms (institutions that facilitate the trading of stocks and ETFs) although more brokerage firms are offering commission-free trading on select ETFs (3). Since ETFs are traded by a brokerage firm, an investor would need to sign up for a brokerage account. While this is not a significant inhibitor to investment, some would prefer being able to directly invest their money into a mutual fund without having to open a separate brokerage account. Because of limited trading, no individual transaction fees, and options for scheduled automatic investment, graduates should be seeking no-load index mutual funds that will help meet their retirement goals.

When it comes to selecting the specific funds, one must consider the tax-efficiency of each type of fund. Tax-efficiency is the general measure of how effective a financial product is at reducing the taxes on the investment. Index stock funds are generally the most tax-efficient investments, opposed to actively managed stock funds and bond funds which are tax-inefficient investments. An investor would typically save money on taxes by holding tax-inefficient funds in a tax-deferred retirement account like an IRA or 401k. These accounts do not charge taxes on the growth that occurs in the account; the investment is only taxed when it is withdrawn during retirement. Some companies even offer a level of 401k matching where an employer will match an employee’s contribution to his 401k account with an equal (or proportional) sum of money. This practically “free” money is meant to encourage contributions to 401k retirement accounts and should be taken advantage of whenever possible (Laibson 121). Tax-efficient assets like index stock funds can be held in either a taxable account or a tax deferred account. Allocating one’s funds to minimize the tax burden will provide a significant increase in return over time.

One financial product frequently suggested for retirement investing is the target date retirement fund – a mutual fund composed of several index funds (typically US stocks, international stocks, and bonds) that allocates a certain percentage of assets to each asset class. The percentage of the assets in conservative funds (typically the bond index fund) increases as the individual ages. This gradual shift to more conservative assets is supposed to accommodate a decreasing risk tolerance (increasing risk aversion) as an investor approaches retirement age. This makes sense because as retirement becomes close, investors will be more sensitive to dramatic price drops that could occur with more aggressive investments like stocks. Since the target retirement fund represents assets of most major classes, it is meant to be the only fund used to save for retirement. For example, if an investor had $100,000 saved in a target date retirement fund and $10,000 in a certificate of deposit (CD) for retirement, his portfolio would be more conservative than investing all $110,000 in the retirement fund. However, this is not necessarily a drawback, as it can be used as a tool to convince risk averse graduates to invest for their retirement while keeping a smaller proportion of their retirement saving in cash. To achieve the highest return the proportion of retirement savings in cash should be small, ideally less than five percent (Barberis 257). It is important to note that this is different from the graduate’s emergency savings fund, which should be in cash at all times. Also since the fund will gradually shift to more conservative and more tax-inefficient holdings, the target date retirement fund should be held in a tax-deferred retirement account. This strategy will minimize loss due to taxes and management expenses since the fund is indexed and tax-deferred. The fund is diversified among many stocks and bonds and represents a mix of asset classes that adjust with diminishing risk tolerance. Simple, automatic contributions can also be established with the possibility for 401k employer matching. The target date retirement fund in a tax-deferred account meets the investment criterion of a strategy that is simple, diversified, low-cost, and long-term.

Given the recent market volatility, it is reasonable for young college graduates to be dubious of the stock market’s future returns. Most investors are risk-averse, and do not want to lose their hard-earned principle. Despite these tribulations, all graduates who meet the necessary investment prerequisites should consider investing for retirement now. The strategy that will be most appealing and encourage investment is simple, diversified, low-cost, and long-term. For those who desire the simplest solution, a low cost target date retirement fund held in a tax-deferred retirement account is the best option. Graduates should also take full advantage of 401k employer matching when available. By encouraging young individuals to take responsibility for their retirement, they can be adequately prepared for retirement, regardless of external benefit programs or market turbulence. Remember, the art is not in making money, but in keeping it.