My sister recently graduated from graduate school and for the first time in her life has had a full-time job with a steady paycheck and benefits. Last weekend, she asked for my help because she gets a 401k but she didn’t have any idea of how to invest it. After setting up her account and reviewing what her investment options were, I thought that the best option was to sign her up for a target date fund. Specifically, Vanguard’s Target Date 2060 Fund.
What is a target date index fund?
A target date index fund is an index fund that invests in a mix of stocks and bonds (domestic and international) that is designed with specific date in mind of when you will need your money. The weighting of how much is invested in each asset class is meant to grow with the stock markets when you are far away from your target date, and get more conservative as you get closer to retirement. My sister, for example, won’t hit 65 until around the year 2060, so her target date fund is heavily weighted towards stocks, with only a small percentage invested in stocks. As she gets older, the fund will gradually move to be invested more heavily in bonds to preserve capital and reduce the risk of her losing a big portion of her savings right when she needs it.
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The progression of how Vanguard shifts their asset allocation is shown below:
Is a Target Date Fund right for you?
There are several benefits to using a target date retirement fund, but the primary one is ease. With target date funds, you have a one-stop-shop for nearly-complete diversification across companies, geographies, and asset classes that automatically shifts and rebalances with time. For many new investors (such as my sister), this is an extremely valuable tool. It is the ultimate set-it-and-forget-it strategy to investing. Even for experienced investors, Target Date Funds may be the best option in your workplace 401k. My workplace offers either high-cost mutual finds that invest in specific asset classes, or low-cost target date index funds. The choice was a no-brainer for me.
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There are some things to keep in mind when choosing a target date fund. The first one is the total lack of control over how your investments shift over time. For some people, the asset allocation Vanguard offers may be different than what they would prefer. They may prefer a more conservative allocation, with more weight towards bonds. These are pretty easy problems to solve, either by choosing and early-then-actual retirement date fund (ex. 2045 fund instead of 2060) or by making an additional side investment to adjust your total portfolio allocation (ex. allocating money to an international bond fund).
The second thing to keep in mind is that even after you hit your date, your money is still invested in a mix of stocks and bonds that both go up and go down. During the financial crisis, target date funds got a bad rap because many lost money during the crash. People mistakenly thought that when you hit the target date, your money was somehow immune from stock market movements. I think this argument is rather ridiculous and utter nonsense, but it is worth pointing out any misconceptions that people have about target date funds.
For beginners and knowledgeable investors alike, the target date fund can be a very useful tool for investing with your 401k or IRA. Simply chose which date is closest to when you hope to retire and you’re done. With your investment allocations managed for you at very low cost, you can spend your time on more valuable endeavors, like increasing your income or reducing your spending, or simply enjoying all of the wonderful things life has to offer.