When you start earning income, one piece of advice you will constantly come across in your career journey is saving/investing towards a goal.
This could be down payment for a house, your kid's college, retirement or a business.
There are a plethora of options that you can explore to grow your retirement fund rather, than just stashing your cash in a savings account.
Investing in target-date funds is a low-risk strategy to growing and compounding your savings towards a goal.
In this article, we take a deep dive into what target-date funds are, including their pros and cons so that you can make an informed decision that would suit your retirement goals.
Also referred to as life-cycle funds, target-date funds are a set-it-and-forget approach to investing towards a 'target'.
This investment vehicle offers a structured long-term investment growth over a set period towards a target date.
Though it is usually associated with retirement investing, it can also be used if you want to meet a financial goal within a time frame.
Keeping your target date in focus, the funds automatically rebalances your portfolio with the right mix of stocks, bonds, and money market accounts.
Early in your investment journey, a target-date fund focuses on growth, by having a much larger slice of your portfolio in risk assets like stocks that have high growth potential. As you approach your proposed target date, the fund gradually adjusts your portfolio to safer assets like bonds, mutual funds, etc.
The premise of target-date funds is to take on higher risk when your date is far off, then take a conservative approach as you get closer to the target date.
As such, target-date funds try to find a balance between the risk necessary to build wealth and safer bets to protect a growing nest egg.
Let's say your kids will be going to college in 10 years, and you want to start investing towards it.
This ensures that your funds grow over time while adjusting the risk to protect your portfolio. This adjustment from risk assets to relatively safer ones is known as a glide path.
What makes target-date funds appealing is their hands-off approach and simplicity.
When you invest in a target-date fund, you do not need to worry about how to constantly adjust your portfolio, or find the right mix of assets. This plug-and-play method to investing is suitable if you do not have the necessary financial know-how to choose the right investment, or the time to conduct the research.
It also prevents you from the emotional reactions that come with investing, especially when the market is volatile.
Most investors lose money because they can't control their emotions or reactions to market swings. This forces them to make knee-jerk reactions and chase markets, leading to losses. Target-date funds, on the other hand, take away the emotional pressures that usually accompany twist and turns.
Target date funds offer you a diversified portfolio which helps in managing risk. Spreading your investment across assets enables you to hedge against market cycles and downfalls.
Some target-date funds are more expensive than other options. Management fees could eat deep into your returns, thus making them a bad investment choice.
Since each is a fund of funds, the portfolio you buy into consists of multiple underlying mutual funds, each of which has an expense ratio.
For example, a fund manager may charge 0.31% of assets under management (AUM) while another may charge twice or three times as much. As such, it is important to keep management fees in perspective when you are considering target-date funds to choose from.
You would think that all target-date funds have the same weightings.
However, this is not so. The holdings, as well as the weighing of each target fund, are different. These different compositions have implications for your portfolio returns.
Also, you may find that the fund does not suit your needs. You may want more exposure to stocks and bonds, but the constituents of the fund may be different from what you have in mind.
Another factor to consider when investing in target-date funds is that the underlying funds are also offered by the same fund company.
For example, when you buy a Vanguard target-date fund, your portfolio would be made of other Vanguard funds. The same goes for other fund managers.
This means you are trusting all of your investment to a single fund manager. Given the rising incidences of corporate scandals, you could be taking a huge risk investing with a single fund manager.
Target-date funds may be a quick-meal approach to portfolio management, but recipes and ingredients can vary widely across your menu of offerings.
An important question to ask when choosing among target-date funds:
The philosophy of “through” funds is that life (hopefully) doesn’t stop at retirement. You still may have 20 years or more of living expenses, and the glide path toward safer investments should reflect that.
Different “through” target-date funds may extend the glide path 10, 15, or 20 years past retirement, so choose one that’s right for your retirement goals.
Target-date funds are the default choice for a 401(k).
So if you have a 401(k) and have never changed what's in it, there’s a good chance you already have a target-date fund without even knowing it.
Another way is to open a brokerage account with a fund manager or an online broker.
The minimum initial investment needed to open a brokerage account varies by fund manager. You have to keep in mind expense ratios.
Comparing funds' holdings to see if they are suited to your investment goals.
Another important point to note is that no two funds are the same, even though they may have the same target dates. The differences depend on the asset-allocation strategy of the fund manager.
While the set-and-forget nature of target-date funds is a key feature, it is important that you keep tabs on the fund’s performance to ensure it is still on track to achieving your pre-defined investment goals.
You can do a quarterly, bi-annual, or annual check-up on your target-date portfolio. You must keep in mind that all investments carry risks, and target-date funds are no exception. So while you may set and forget, it is important to do regular check-ups.
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