How to Use a Target Date Fund

jehericosignThe idea of investing is that you increase risk when you have a long time to wait, then decrease risk when you have less time.  The reason is that risky things, such as a growth company, take time to develop and are unpredictable, so you use long investment times to reduce your risk.  It would be very risky to invest in a growth company for a one year period since all sorts of things could happen to both the company and the markets in general during that year.  The stock would be just as likely to be up 20% as down 20% after a year.  If you invest in a good growth company for twenty years, however, you reduce your risk since, if it is a good company with a good product and good management, they will grow if given enough time.  You don’t know when the price of the stock will appreciate.  You just know that it will if things work out like you expect them to.

When you only have a few years to invest, you put your money into things with a more predictable return since it is too risky to try to get the timing right.  You might put your money into a one year CD if you needed to use the money for something in a year since you could predict exactly, assuming that no major financial collapse or Armageddon occurred, what your investment would be worth in a year.  If you were investing for five years, you might buy bonds in solid companies that were due to mature, meaning that the company would repay the loan and hand you a check, within the five-year period.

The issue with sure things like CDs is that they don’t pay anywhere near the return that things like growth stocks do.  In fact, over time your purchasing power may decline since interest rates on CDs don’t usually keep up with inflation.  With stocks you get rewarded for taking the extra risk, plus the value (in number of dollars) of the company increases automatically with inflation.  Because there is a real chance that you could lose money, the return when you do make money is enough to make up for the risk.  It is kind of like if you were lending to a friend who you knew would pay you back versus some random guy who just asked to borrow a few dollars for lunch.  You would probably loan to your friend, probably without charging interest.  You might loan to the random guy, but only if he offered to pay you back twice as much the next day.  You would figure that you might lose the money, but then again you would double your money if things work out.

When saving for retirement, one strategy is to start out invested almost entirely in stocks when you are young and have a lot of time, but then shift more into bonds and other more predictable investments when you get closer to needing the money.  One idea is to invest your age in bonds and put the rest in stocks,  When you’re twenty, you would put 20% of your money into a bond fund and 80% of your money into a stock fund.   When you reach forty, you would sell some of the stocks and buy more bonds, bringing your bond portion to 40% and reducing your stock portion to 60%.  About the time you were ready to retire at age 65, you would be 65% in bonds and only 35% in stocks, greatly reducing the damage that would be done should the stock market turn down.  Even if bond prices fell at that point, you could live off of the yield from the bonds and just wait for them to mature.

Target retirement funds were designed to automate this process for the buyer.  They were designed for people who either didn’t have the time to shift money from stocks to bonds – a time commitment of about 15 minutes, after you remember the password for your 401k account,  once per year – or who just didn’t want to learn how to invest directly.  These funds automatically shift from stocks to bonds and other fixed income securities as the target date approaches.  The idea is that you would pick a target date fund with a target close to your retirement date, allocate your 401k contributions to it, then forget you own it.  For example, if you are 20 years old today, your retirement age would be 45 years from now, or the year 2040.  You would find a Target2040 fund from among the selections in your 401k plan and direct your money there.  Done.

Well, maybe not so fast.  The issue with these funds is that some of them are more aggressive than you think, and some are less aggressive.  Funds with the same target date from different fund companies might contain different ratios of stocks and bonds.  The one with more stocks would perform better over long periods of time, but change value more quickly.  That with more bonds would not generate market returns, but change in price more slowly.  In up markets you would be losing return.  In down market you would be happy to not be losing as much as the S&P500.  Fund fees are also an issue, since high fees (1% or higher) will eat away at your returns, costing you hundreds of thousands of dollars over your career.

One strategy is to look at the returns of a target fund versus the market (the S&P500) or against each other and pick the one that matches your investment style and comfort level.  If you want more return, buy the fund that has the higher returns during up markets and larger losses during down markets.  If you want more stability, buy the one that both goes up and down less than the S&P500 and other funds with the same target date.  Also, you could buy a target fund with a target date farther out than your retirement date if you want greater returns and don’t mind the volatility, or sooner than your retirement date if you want more stability.

Personally I don’t mind volatility.  I see no reason to give up several percentage points of return over a working lifetime.  Sure, this means that my portfolio may crater by 40% during an extreme market crash like in 1999 or 2008, but I just see it as an opportunity to pick up shares cheaply.  I also don’t need the money for several years and know that it will recover if given time.  Many market drops correct within about a year.  Almost all are fully recovered within a five-year period.  I  therefore plan to be fully invested in stocks until I am at least fifty, then start to shift into some income securities to preserve my gains.  This would be a bad idea for those who can’t stand to see their 401k balance drop, because I will at times, but it is the best course based on past returns.  But that’s just me.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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