Don’t be fooled. The easiest option can also be the best option.
You already know I’m a big fan of making things easy, especially investing.
And, there is no better example of making things easy than investing in target date funds.
Maybe we’ve been brainwashed into thinking that the harder something is, the better it is. Of course, there’s that often-repeated phrase, “If it were easy, everybody would do it.”
We’ve been programmed into thinking that “hard work” automatically means “better results.”
I certainly agree that hard work pays off when it comes to things like career and exercise.
As another example, baking cinnamon rolls comes to mind. With cinnamon rolls, the harder way is probably also the better way.
My daughter and I bake pre-made cinnamon rolls every week. We have fun with it and it’s quick and easy.
She loves how they taste, so that’s all that really matters. But, they don’t come close to tasting as good as homemade cinnamon rolls, which are certainly harder to make.
So in the context of cinnamon rolls, I think “harder” does mean “better.”
On the other hand, I don’t agree that investing has to be hard. I don’t believe that just because something is easy, it must not be that good.
And, that brings us to target date funds.
There’s nothing easier than investing in target date funds.
My wife and I have been investing in target date funds for years. Target date funds have been both easy and effective for us.
That’s important because we’re also at the stage in our lives where we are trying to make things easier, not harder.
The idea behind target date funds is that your portfolio automatically rebalances as you move closer to your predetermined life event, like retirement or your kid’s college start date.
That means over time, your target date fund will gradually become more conservative to protect all the money you had saved and earned over the years. It typically does so by reducing exposure to stocks and increasing exposure to safer assets, like bonds.
You do not have to do a thing.
It simply cannot get any easier than this.
Today, we’ll take a closer look at how target date funds work. The goal is to help you make an informed decision on whether they are the best option for your situation.
Before we jump in, if you need a refresher on some key investment terminology, check out my post on the language of investing:
What are target date funds?
Target date funds are a form of mutual fund. When you invest in target date funds, you are essentially getting a complete portfolio in a single fund.
Target date funds are typically comprised of broad stock index funds and bond index funds.
That is one of the keys to remember about target date funds. They automatically provide investors with strong diversification and optimal asset allocation based on their chosen time horizon.
Target date funds are ideal for long-term investment goals. They are designed to help you manage risk as you move closer to your pre-determined goal.
Typically, target date funds invest more heavily in stocks in the early years in an effort to earn greater returns. As you move closer to your pre-determined goal, the fund will automatically shift to buying safer assets, like bonds.
What types of investments are typically in target date funds?
Most target date funds are made up of index funds. That means that when you buy a target date fund, you are getting exposure to a wide variety of stocks and bonds through index funds.
An index fund is a type of mutual fund that seeks to track the returns of a market index, like the S&P 500 Index.
As explained by Vanguard:
An index mutual fund or ETF (exchange-traded fund) tracks the performance of a specific market benchmark—or “index,” like the popular S&P 500 Index—as closely as possible. That’s why you may hear people refer to indexing as a “passive” investment strategy.
Instead of hand-selecting which stocks or bonds the fund will hold, the fund’s manager buys all (or a representative sample) of the stocks or bonds in the index it tracks.
It’s very hard, even for professionals, to beat the returns of the S&P 500. Historically, the S&P 500 has averaged an annual return of 10%.
I Invest in target date funds because they give me a great chance to match those historical average returns without any effort on my part.
What are the advantages of investing in target date funds?
Target date funds share the same benefits as investing in index funds. That’s because, as we just discussed, most target date funds are comprised of index funds.
In addition to the benefits of index funds, target date funds offer one additional major benefit we’ll discuss below.
By the way, you already know 7 things I love about index funds:
- Anybody can do it
- No wasted mental energy
- Low fees
- Automatic diversification
- The closest thing to predictability
- I don’t have stock FOMO
- Good enough for Buffett, good enough for me
For a more in depth look, check out my post here:
Target date funds automatically rebalance
In addition to sharing the 7 benefits of index funds, target date funds offer one additional, major benefit:
automatic rebalancing
Importantly, target date funds automatically rebalance to continuously maintain your optimal mix of stocks and bonds.
That means as time goes on, you don’t have to worry about rebalancing on your own. That’s one less stressor on your plate.
What do I mean by rebalancing?
Let’s say an investor’s optimal asset allocation is 50% stocks and 50% bonds. After a year of impressive stock market growth, this investor’s portfolio now consists of 60% stocks and 40% bonds. That’s because his stocks increased in value at a greater rate than his bonds.
As a result, he’s now weighted more heavily in stocks than his optimal asset allocation. To rebalance his portfolio, he could take a variety of steps. He could sell some stocks or purchase more bonds to get back to where he wants to be.
With target date funds, he would not have to worry about this situation. That’s because target date funds automatically rebalance for you.
That’s a big load off an investor’s plate. It’s the main reason why I like investing in target date funds.
Target date fund or build your own?
After you open an investment account, you can select a combination of index funds on your own or choose a target date fund.
There’s nothing wrong with buying index funds on your own instead of through a target date fund.
You will actually save money on fees if you go that route, but not very much.
For example, the popular Vanguard Total Stock Market Index Fund (VTSAX) charges a fee of .04%.
Vanguard’s Target Retirement 2065 Fund presently charges a fee of .08%.
Just remember to rebalance your portfolio from time-to-time to stay within your preferred asset allocation.
If you don’t want that added responsibility, you can invest in a target date fund that automatically chooses the index funds for you.
Then, the target date fund will automatically rebalance your portfolio over time to maintain an optimal balance of stocks and bonds.
As you saw above, you will pay slightly more in fees for the added convenience. To me, that extra .04% in fees is absolutely worth it.
In the end, both options are good ones.
Investing with target date funds is the easiest choice.
How can you invest in a target date fund?
Most employer-sponsored retirement plans, like 401(k) plans, now offer target date funds. In fact, target date funds are usually the default investment option for new plan participants.
You can also invest in a target date fund outside of your employer-sponsored plan. Most major investment companies offer target date funds in a variety of account types.
In addition to retirement accounts and traditional brokerage accounts, 529 college savings plan providers usually offer target date funds based on when your child will start college.
If you’re curious about my favorite investment account types, you can read more here:
Regardless of the account type, the process for selecting the right target date fund is the same.
Generally, you’ll see various target date fund options based on your personal time horizon.
For example, if you are currently 25-years-old and plan to retire in 40 years, you would select the target date fund corresponding to 2065. This fund will automatically rebalance as your career progresses towards that retirement date.
Typically, there are target date funds offered in 5-year intervals. Choose the one closest to your preferred retirement year, even if there isn’t one that matches your exact year.
The same concept applies to a 529 college savings plan. If you have a newborn, like I do, you would select the plan that corresponds with your child starting college around 2043.
After you make this one decision, there’s nothing more to do it.
Your focus should be on adding as much money to that account as possible without worrying about things like rebalancing.
I personally invest in target date funds.
My wife and I invest in multiple target date funds. We have various target date funds for our retirement savings and for our kids’ college education.
At this stage in our lives, we’ve placed a premium on doing things the easy way.
We have full-time jobs as attorneys, manage our own rental properties, and have three kids at home. The last thing we need is to add more complication to our lives.
Our personal accounts are with Vanguard, which has long been known as an investor-friendly company that prioritizes low fees.
Why target date funds?
Just because something is easy doesn’t make it wrong.
Investing in target date funds is as easy as it gets. By taking the easy option, you can have exposure to a broad range of index funds that automatically rebalances over time.
Are you doing things the easy way?
If you’re a busy professional like I am, don’t sleep on target date funds.
You’ll always have people that look down upon target date funds as too basic. Ignore them. Let them stress about picking the next hot stock, rebalancing, and timing the market.
- So, are you doing things the easy way? Are you a target date fund investor?
- Do you agree that target date funds are an easy and effective way to invest for the long term?
- Has anyone ever looked down on you for investing in target date funds?
Let us know in the comments below.