I can tell you from experience that diversifying your portfolio can be a real headache if you aren’t sure of the proper way to do it. You could end up owning a large number of stock funds and bond funds. It can get even more complicated trying to diversify using equities. You could find yourself holding 20 or 30 different stocks. Trying to keep up with that many different investments could drive you insane.
So, what is an investor to do? The simple solution that can fit your investing needs is a target date fund. Target date funds take the guesswork out of diversification. Target date funds create a portfolio for you based on your estimated year of retirement. They determine the right portfolio mix based on how many years left until retirement and they rebalance all of your assets the closer you get towards retirement age. The older you get, the more conservative your investment portfolio becomes.
Advantages of Target Date Funds
The advantages of target date funds are they adjust the portfolio mix every year. The fund does all of the heavy lifting for you. The fund would be structured so that its mix would be heavily weighted towards stocks and other growth assets when you are young. The main focus is capital appreciation. The fund automatically readjusts as you get older. The focus shifts from capital appreciation to capital preservation. Here’s how it works:
Let’s say you are 30 and invested in a 2045 target date fund. The fund’s mix would be 70% stock, 25% bonds, and 5% cash. Every year the stock percentage would decrease and the bonds and cash percentages would increase. In 2045 when you reach retirement, the portfolio would be 70% bonds, 20% stock, and 10% cash. Your assets would be protected from market fluctuations. This is critical since most retirees live on a fixed income and need a stable steady income source.
Disadvantages of Target Date Funds
The main drawback to target funds is the “one size fits all” approach. Since every investor is not the same, it is possible that a specific fund does not meet all of your needs. An older investor with limited savings may need to be moderately aggressive to achieve capital growth. A target date fund would not accomplish this goal for that individual.
Another problem is that target date funds may not be structured as conservatively as they should be. Older investors sometimes complain that some target date funds dropped nearly as much as the overall stock market during the market crash of 2008. Some senior citizens lost as much as 41% of their portfolio’s value.
More employers are including target date funds as an option in 401(k)’s. If you want to invest in a target date fund, don’t worry if your employer doesn’t offer a 401(k) option. You can invest in one yourself through a Traditional IRA or a Roth IRA. Most reputable mutual fund companies offer target date funds. Do your homework before investing. Check with Morningstar for the rating of your fund. Remember that although target date funds do most of the work for you, you should still review your fund annually to make sure that it is suitable for you.
If you’re looking into funds right now and want some more general tips, be sure to check out these other tips on how to choose the right funds for your 401k.
What is your opinion of target date funds? Do you currently invest in one?
(Photo credit: thelastminute)