It’s easy to select a good asset allocation for your nest egg on your own, but if you don’t have the discipline to stay balanced, a target-date retirement fund could be your best option, says Money Magazine’s Walter Updegrave.
Question: I’ve got my 401(k) invested in a target-date retirement fund. I’m wondering, though, whether I would be better off investing it in large-cap, mid-cap, small-cap and blended funds, putting 25% into each option. What do you think? –J. Duffaut
Answer: You’ve no doubt heard the expression, “First, do no harm.” (You scholarly types may be more familiar with the Latin version, “Primum non nocere.”)
It’s a bedrock principle that all good physicians adhere to. The idea is that a doctor shouldn’t dole out medicine or prescribe a treatment that has an uncertain benefit for the patient but may have a good chance of causing harm.
In other words, a doctor must consider the downside before intervening.
Well, I think that individual investors – and particularly people who are building a nest egg for retirement in a 401(k) or similar account – ought to take this principle to heart as well.
Take the case of 401(k)s and target-date retirement funds. The number of 401(k) plans offering target funds has mushroomed over the past few years and more and more participants are plowing their contributions into this option. I think the growing popularity of target funds is good for two reasons:
1. They make retirement investing easy. Just choose a target fund with a date that roughly matches the year you plan to retire, and you get a ready-made diversified portfolio of stocks and bonds that’s appropriate for someone your age. What’s more, the fund automatically shifts its mix more toward bonds as you age, so that you take less investing risk as you grow older.
2. They can save us from our own worst impulses. Here I’m talking about our tendency to chase hot funds and sectors, buy into inflated asset classes and pour too much money into company stock and other investments that may be risky but we don’t necessarily see as risky. In short, target funds make it harder for us to sabotage our own retirement planning efforts.
Are target funds perfect? Of course not. But if your 401(k) offers this option, then it seems to me that before you reject it in favor of other funds, you ought to ask yourself: Can I do better on my own?
The answer may very well be yes. You don’t have to be an investing savant to put together a decent portfolio of stock and bond funds. But you do have to take responsibility for creating and maintaining a workable investment strategy – that is, deciding on a reasonable mix of stocks and bonds, choosing appropriate funds, monitoring their performance and then rebalancing your portfolio once a year.
If you don’t know enough about investing to do this or you’re not willing to put in the fairly minimal time and effort needed to do it (or you know deep inside that you’ll probably give in to the urge to tinker often enough that you may undermine your efforts), then it seems to me that taking an active approach has the potential to do more harm than good. In which case, I’d say you’re better off with a target fund.
Now, I don’t know you well enough to judge how capable or responsible an investor you are. But based on your question, my guess is that you’re probably a good candidate for a target fund.
Why? Well, you talk about putting equal amounts of money in large-, mid- and small-cap funds. That means you’ve got twice as much money in mid-size and small stocks combined as you do in the big boys. (Let’s leave the “blended” funds aside since I’m not sure what kind of funds you mean.)
But if you take a look at the percentage of total market value that large-, mid- and small-cap stocks actually account for in the stock market, you find that large stocks represent almost 75% of market value and mid- and small-caps combine for the other 25%. (You can see this for yourself by plugging the stock market ticker for Vanguard’s Total Stock Market Index fund—VTSMX—into the Instant X-Ray tool.)
This means that investors as a whole have allocated about three times as much of their capital to large stocks than medium and small ones. You, on the other hand, are proposing to do pretty much the opposite by putting twice as much in the mid-size and small stocks.
If you’re doing this because you believe you have insights that investors overall lack – in effect, you think they’ve made the wrong decision – then fine, maybe it makes sense to go so far against the grain. But if you don’t have insights or information the rest of the investing world doesn’t have, then I don’t see how you can justify divvying up your money as you’ve suggested.
Either way, I can tell you that by piling so much into mid- and small-size stocks (and putting nothing in bonds, unless they’re in your “blended” category), you are creating a very volatile portfolio that, if nothing else, is virtually guaranteed to give you a white-knuckle ride.
So I guess I would answer your question with one of my own – namely, how did you come up with that 25%-in-each-group strategy? And unless you have a very cogent reason for it, I’d say you’re better off sticking with your target-date fund.
That’s not to say, however, that at some point in the future you can’t switch out of your target-date fund and into a portfolio of individual funds you’ve created. But for that to make sense, I think at the very least you would want to have read a few of our Money 101 lessons, starting with the basics of investing, then moving on to stocks, bonds, mutual funds, asset allocation and, of course, retirement planning.
Until you do that, however, I say your first obligation is to do no harm, which means staying put in that target-date fund.