When a person I met heard I’m knowledgeable about investments, she asked my suggestion for how she should invest in her SEP IRA, where she had most of her investments. Because she had her account at Fidelity, I suggested that she picks a Fidelity Freedom Index fund.
I did so not because I thought she was a newbie. I made the suggestion because target date funds such as Vanguard Target Retirement funds, Fidelity Freedom Index funds, and Schwab Target Index funds have a unique advantage in helping investors stay the course and avoid behavioral mistakes.
Arguably avoiding behavioral mistakes has a much larger impact to the investment results over the years than many other aspects. Having everything mixed together as one object forces you to look at the portfolio level as opposed to at the individual components level. When you only have that one thing, that’s the only thing you can look at.
When you have individual components, although you can still look at the sum total, you can’t help but look at the components and see the moving parts. Different parts will move in different ways at different times. The more moving parts you have, more often than not something isn’t working. Our good nature will make us try to fix it. When stocks do well, you wonder why you should have that much in bonds. When stocks do poorly, you wonder whether you should cut back.
We are very good at justifying any action our emotion takes us. When international stocks do well, we hear we should go with the global market weight (~50% in international). When international stocks do poorly, we hear Jack Bogle says U.S. companies already get a large percentage of their business from outside the U.S. anyway. When value stocks do well, we point to Benjamin Graham, Warren Buffett, and the Fama-French 3-factor model. When value stocks do poorly, we hear the value premium is already fully arbitraged away. When REITs do well, we hear it’s an under-represented asset class with low correlation to stocks. When REITs do poorly, we hear they are just a sector bet.
Whatever we are drawn to do, we can always find theories to support it. A little knowledge is a dangerous thing.
When someone invests in a target date fund, and only the target date fund, it’s driven by the planned retirement year. Whatever happens in the markets does not affect the year. When the Dow dropped 1,200 points, did the target year change? No, so no change is necessary. This is born out by data from Vanguard. In its latest study, 8% of retirement plan participants made a trade in their 401k plan in a given year. Among those who invested 100% in a target date fund, only 2% made a trade. Source: How America Saves 2017, page 5, Vanguard Institutional Investor Group.
When you have fewer moving parts, you are simply less compelled to make a change. The changes we are compelled to make are often counterproductive.
We can easily point out the flaws of target date funds:
One size fits all – Why should people planning to retire around the same time all have the same portfolio? What about their difference in risk tolerance and their need to take risk?
Tax efficiency – Having bonds in a taxable account
isn’t may not be the most tax efficient (see comment #2 below).
Cost – Investing in individual components separately can save up to 0.10% in expense ratio.
Momentum – Daily rebalancing forfeits the benefit of short-term momentum.
It’s all true, but the one unique advantage of a target retirement fund can overcome all these flaws. It doesn’t distract you. For this reason I say the target date funds are underrated. Granted not all target date funds are as good as the three series from Vanguard, Fidelity, Schwab, but if you are with one of the big three, they are very hard to beat. Overconfidence makes us think we can do better. Chances are we aren’t actually doing better than these target date funds.