When I first started working, the task of determining my 401(k) allocation was quite overwhelming. I was barely out of college and had hardly picked up a financial book and was thus in no position whatsoever to pick the set of funds that were right for me and my retirement goals. A colleague must have noticed my wide eyes and bewildered look and suggested that I put all of my 401(k) money in the Target Fund that best approximated the year at which I will presumably retire. That seemed like a good idea at the time and so I did just that. Within 6 months I had altered my 401(k) allocations to exclude all Target Funds.
Target Funds are predicated on the idea that a diverse portfolio is optimal and that an individual’s investment mix should grow more conservative as they move closer to retirement, and are subsequently built with those two principles in mind.
Diversification – Diversification is one of the primary tenets of investing in general (“don’t put all your eggs in one basket”) and is especially important when attempting to grow your retirement nest egg. It is the primary risk management technique that you will use to ensure that the decline in value of one security will have a minimal effect on the value of the portfolio as a whole.
The critical importance of having a decent chunk of money available when you retire dictates that a diverse portfolio – and thus a safe and stable portfolio – is absolutely essential. There are many ways that you can diversify. You can spread your investments over a variety of different asset types (stocks, bonds, cash, for example), or perhaps you can allocate your assets over a series of funds with varying risk (index funds vs. small-cap funds vs. international funds) or across funds that are representative of different industries.
A solid portfolio strategy would employ all three types of diversification. Target Funds attempt just that. For example, according to Vanguard, my general preferred asset allocation breakdown is as follows: Domestic Stocks (72%), International Stocks (18%) and Nominal Bonds (10%). That asset allocation has some diversity, but it isn’t as diverse as it could be, which introduces risk. But that is done for a reason, and is explained by the next point.
Conservatively Growing Asset Mix – A general rule of thumb is that the longer your investment window, the more risk you should be able to stomach, given that you have enough time to earn back those losses. Conversely, as you grow older and that window shrinks, you should have a more conservative mix of investments, to protect the money that you have spent years earning. So when you (hopefully) start investing young, it’s suggested that you take on more risk in your fund selection (by selecting International Funds, Aggressive Growth Funds and Small-Cap Funds) and then gradually over time move to a more conservative mix (such as Money-Market Accounts, Bond Funds and Balanced Large-Cap Stock Funds).
For example, someone electing to invest in Vanguard’s 2010 Target Fund would see an asset allocation of 40% Domestic Stocks, 40% Nominal Bonds, 10% International Stocks and 10% Inflation-Protected Bonds. That is obviously a much more conservative fund allocation than the one recommended for someone my age.
No Comments yet!