Sunday, May 5, 2013

What Is A Target-Date Fund?

One of the most important decisions investors have to make is “asset allocation” or the percentages we hold in each of the major classes of investments; stocks, bonds, real estate, and cash. This decision reflects the level of risk a person assumes and the amount their portfolio is likely to grow over time. This is a difficult decision and one that requires careful consideration.
How much risk can you stomach? How much can you afford? How much growth do you need to meet your retirement nest egg goal? Ultimately the question is, what is the right mix of stocks and bonds to get the growth that you need to retire? And to make matters more complicated, the mix (or, asset allocation) will change as we age.

How The Mix Changes
A younger person can withstand more risk, more ups and downs in the market, and therefore may safely hold more stocks and fewer bonds in the portfolio. The logic here is that over a relatively long time horizon, stocks will grow in value faster than inflation, providing the needed progress towards retirement goals. As we age though we need to lower our risk by reducing the percentage of stocks in the portfolio.

When the retirement date arrives, the amount one can draw from investments depends on the value of the nest egg. Clearly, holding all stocks represents a big risk to an investor approaching retirement should he or she encounter a serious bear market. The value of the portfolio may be hit hard, without sufficient time to recover.

The Answer To The Question
Here’s where the target date fund concept comes in. The target date fund automates the process of adjusting the asset allocation mix over time. The investor simply indicates the year in which he wants to retire. For instance, if you are 40 now and hope to retire in 25 years, you’d pick a fund dated 2038. As you age, the percentage of stocks will decrease over time.

The Rub
Sounds painless, right? Make one decision, “set it and forget it.” Difficult decisions automated, problem solved. Unfortunately, the “easy answer” isn’t always best, especially in our volatile and changing times. Target date funds for 2038 could be quite different from one another in terms of risk, and they often differ in how the asset mix changes over time.

Target date funds did poorly in the 2008-2009 bear market. Meaning a fund with a 2009 target date still had such high stock exposure that the value plummeted along with the stock market. Imagine if you were set to retire that year and that was your biggest investment. Clearly this is a topic worthy of more discussion.

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