If you like a hands-off approach to investing, you might be drawn to a target date fund.
These mutual funds, which are popular among investors saving for retirement, invite you to essentially buy in and then forget about it. You set a target date, presumably around the time you want to retire, and the fund automatically rebalances your holdings as the date approaches, moving in an increasingly conservative direction of fewer stocks and more cash and bonds.
Sound too good to be true? Well, maybe it is. Here are some things to consider before you fund your retirement with a target date fund:
- There are no guarantees. There seems to be a subtle subtext that goes along with the idea of rebalancing your portfolio as you age, which suggests that this is somehow a safe strategy. But don’t be mistaken. Target date funds don’t come with any guarantees. The part of the fund that is held in stocks, however small, may be subject to wild swings. And even if these occur early in the life of the fund, they could be hard to recoup.
- You may pay hefty fees. Because target date funds, by definition, move in and out of different investments over time, there’s a great potential to pay substantial fees over time. And as a “fund of funds,” you will likely be subject to the expense ratios of both the target date fund itself and its underlying mutual fund holdings. Research this before you commit.
- Rebalancing sometimes means selling winning stocks. As an independent investor, you might opt to hold on to a stock that’s doubled or tripled in value, even as you approach retirement, if you believe that it’s still a growth engine. But because target date funds are designed to rebalance according to a schedule, that means that some higher-growth investments will inevitably be sold in favor of balancing the overall portfolio and gradually lowering your risk. The fund’s formula for rebalancing your portfolio will effectively override some considerations about the merits of individual investments. You could miss out on some strong gains.
- There is no single formula for a successful retirement. While it’s a basic rule of thumb that you should lower your risk profile as you move closer to retirement, in truth it’s a lot more complicated than that. If you have a substantial nest egg in cash, it may make sense to invest your limited stock holdings in growth stocks. Outside circumstances may also cause you to adjust your own strategy. Say there was a deep bear market in your prime investing years that left you with a shrunken portfolio as you approached retirement. In such a scenario it may make sense to hold more stocks to try to recoup some of those losses. Markets, after all, go through cycles, which won’t always align with the tapered approach of a target date fund.
- Different funds, different philosophies. Wouldn’t it be nice if there really was a magic number, or a magic formula? In reality, we’ll all need different amounts to meet our retirement goals. Likewise, there are all sorts of different philosophies out there about how much risk you should take on in youth, middle age and as you approach retirement. Target date funds seek to get you the proper balance, but different funds managers will have different thoughts about how you should be balanced in retirement. If you decide to go the target date route, do your research and find a fund that fits your philosophy.
- You don’t have to align the fund with your retirement date. Yes, the stated purpose of target date funds is to prepare for retirement, but maybe you have other objectives. Maybe you want to retire early and continue to invest aggressively for several years. In this case, it might make sense to purchase a target date fund when you retire and set the target date for several years from then.
- You don’t have to put all your assets into a target date fund. While a target date fund is designed to balance your portfolio, you can also achieve greater balance by investing a fraction of your portfolio in this sort of fund.
- There are worse things than low returns. Finally, while it’s fair to point out that you might miss out on strong gains by investing in a target date fund, it’s necessary to also point out that there are worse things than small gains. If the fund has helped you avoid steep losses at that point in your life when you are no longer earning income, that’s worth celebrating.
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