No professional Investment Adviser would invest his or her personal money in a target date fund, so why should you? Target date funds are an option to start investing but are too objective in a subjective world. What they do offer is simplicity and instant diversification, something investors just starting to save need access to. However, as we quickly advance in our careers a simplistic approach is often the wrong approach. While target date funds are an investment option for beginners who are looking to take the guesswork out of choosing an ideal asset allocation, they are far too generic to allow us to meet our individual goals in retirement.
We have all heard the benefits of target date funds as they are heavily marketed through popular index providers, but there are drawbacks. Here are the 4 biggest headwinds facing target date funds:
- Market Conditions
- Risk Tolerance
- YOU’RE NOT AVERAGE!
Cost: If you are investing in a target date fund through an employer retirement plan such as a 401(k), it is critical that you compare those fees to other fund options. Target date funds are what we call funds of funds, essentially a fund containing mutual funds as holdings rather than a fund containing individual stocks and bonds as holdings. The result is that many target date funds charge an additional management fee on top of the fees associated with the underlying mutual funds, which can quickly add up.
Market Conditions: While target date funds may have some actively managed mutual funds, their approach is consistent with a passive investment strategy. The underlying theory of a passive investment strategy is what is known as ‘random walk theory’; essentially there is no predictability in the market of which its sum is the result of random performance. However, there is a lot of research-backed evidence that shows specific asset classes and sectors of the market perform better under certain market conditions, thereby helping active managers provide superior performance.
Target date funds may move you into asset classes that aren’t appropriate for the current economic climate. For example, when interest rates rise, bond prices fall. This can have a negative impact on bond funds. However, as you get closer to retirement, a target date fund will allocate more of your assets to bond funds at a time which may prove costly. These sort of market conditions are not considered by target date funds and could put you at more risk, which an active manager could help mitigate.
Risk-Tolerance: Target date funds have zero consideration of your individual risk tolerance. Would you consider yourself a conservative investor? Or maybe a growth-oriented opportunist? Target date funds don’t care and herein lies the flaw with their inherent objectivity. Risk tolerance matters because it determines how each individual will react when the market fluctuates in the short-term. When is enough, enough? Would you sell and go to cash if you lost 10% of your assets? How about 30%? 40%? Your success with investments is in large part determined by your ability to take the emotion out of investing. But as humans, emotions will always play a part in our decision-making. Considering each person’s unique risk-tolerance can help avoid knee-jerk reactions to short-term market movements by not taking more risk than is necessary or appropriate.
YOU’RE NOT AVERAGE: Not all retirements are the same. Target date funds are built on the model of the average person with one common goal: the year they retire. But are you average? Do you have longevity in your family? Is your spending average (average expenses in retirement are about $60,000/yr. total)? What about your family? Will they depend on your savings too? Do you have philanthropic aspirations? An appropriate asset allocation depends on your unique goals and circumstances because… you are not average! We are defined by more than the year in which we retire.
For example, imagine two individuals who both plan to retire in 2022 and invest in a 2022 target date fund. Do they have the exact same situations that allow the investing in a target date fund to be adequate? If one individual is retiring at the age of 55 and the other individual hopes for two extensions for a retirement at the age of 62, should they invest in the exact same thing? The answer quite simply is no.
Target date funds are an investment option, but they are not the best choice. There is not a one-size-fits-all solution to investing. Appropriate asset allocation depends on much more than the date in which you retire. Your personal goals, accumulated wealth, and risk tolerance are just a few of things that should also be considered. While target date funds are an option for those just getting started, for those with accumulated wealth or in peak earnings years, choosing a target date fund could leave you with too much or too little risk to meet your own unique goals.
If you would like to receive a free Savings Plan Asset Allocation to help best allocate your portfolio to meet your needs, please contact Mark Shane at [email protected].