You might have figured out by now that I like to keep things simple, especially when it comes to building portfolios and reaching financial goals. But don’t think for a moment that when you keep things simple, you sacrifice anything in the way of sophistication or, most of all, performance.
In fact, I wouldn’t be surprised if there was an inverse relationship between the number of securities held in a portfolio and performance. Following that logic, could a one-fund portfolio top them all? Absolutely! Let’s take a closer look.
The good news is that most retirement plans now offer target-date funds that cover the first two principles, allowing you to focus exclusively on the third principle. A target-date fund is a mutual fund that consists of three or more stock and bond funds, where the allocation between stocks and bonds automatically rebalances toward a more conservative portfolio as you approach a targeted retirement year.
For instance, Vanguard’s Target Retirement 2015 Fund has a stock-to-bond allocation of 50-50; its Target Retirement 2030 Fund is 75 percent stocks, and the Target Retirement 2060 Fund is even more aggressive at 90 percent stocks.
I am a huge proponent of target-date funds for three reasons:
Simplicity: These funds offer portfolio diversification on par with the largest of pension funds. On top of that, target-date funds that are made up of index funds assure you will approximate the market’s performance and maximize your return in each asset class over time.
Investor behavior: Research by the Employee Benefit Research Institute found that 97.2 percent of investors who automatically contributed to target-date funds in a retirement account stayed fully invested through the bear market of 2008. Compare that to general investor behavior in early 2014, when a minor 5 percent setback in the stock market caused investors to pull $28.3 billion from equity funds and pump $14.8 billion into bonds, both weekly records, just before the stock market resumed its bull run that continues in 2015.
Automatic rebalancing: The manner in which your portfolio is allocated between stocks and bonds has a far greater impact on its long-term return than the individual securities within your portfolio. Target-date funds automate this process based on your specific fund selection, and automatically rebalance to a more conservative allocation over time.
A word of caution about target-date funds is in order, though. As many investors painfully discovered during the bear market of 2008, these funds aren’t insulated from volatility. It is essential, especially if you are nearing retirement, that you have a keen understanding of the fund’s allocation between stocks and bonds and your ability to endure a bear market.
For example, if you are planning on retiring in five years and have selected Vanguard’s Target Date 2020 Fund with a 60-40 stock-to-bond allocation, a dip of 25 percent in stocks and 10 percent in bonds next year would mean a portfolio decline of 19 percent. The time to emotionally prepare for the next bear market, and its impact on your financial life, is now. Through the periodic updating of your financial plan, you can model the scenario of a 19 percent market decline and how that will influence your saving (and spending) goals of today.
The No. 1 benefit of target-date funds is that they offer you the confidence to focus all your retirement planning energy on your spending and saving goals. That is what building wealth is all about.