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.
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I like target date funds. I was recomended them when I started out. After I attempted to pick stocks. They sure helped my until I understood a little more about investing.
I would encourage you to look at Paul Merriman’s Two Funds for Life. It is a mixture of a Target Date Fund (ideally a Target Date Index fund) and a value index fund, usually a small cap value. The back testing numbers are pretty impressive. One of his colleagues is publishing a book on it soon.
Best of luck!
“Tax efficiency – Having bonds in a taxable account isn’t the most tax efficient.”
Is this no longer the case anymore with the new tax code? We are still in a low interest rate environment and the difference between ordinary rates in the 25% bracket and qualified dividends is only 7% in 2018. I believe you alluded to this in a post titled Tax Efficiency: Relative or Absolute
Harry Sit says
I should’ve said “may not be the most tax efficient.” Because they are intended as long-term investments, being tax efficient today may not be the case in the future when interest rates are higher. In the early years bonds make up a small percentage of the fund anyway. So even if it isn’t the most tax efficient, the effect is very small, compared to the unique benefit of having everything blended together.
What’s your thoughts on T Rowe Price target date funds?
Harry Sit says
Unlike Fidelity and Schwab, who at least offer a series of target date funds that invest in index funds, T. Rowe Price stands firmly to its active management. Their target date funds are more expensive. Whether their active management will overcome the added expense is not clear. If I don’t have a choice because my 401k is with T. Rowe Price I would consider using their target date funds but I wouldn’t go out of my way to buy them on my own.
I hear the arguments for lower expense ratios, but even taking into account, T Rowe Price has had a little higher returns over the past 12 years (TRRDX vs VFORX) – I keep hesitating to switch because of this.
Harry Sit says
[I shortened your link to make it display better.]
A Morningstar analyst said this about the T. Rowe Price Retirement series:
“The series’ above-average equity allocation has resulted in above-average volatility. But the funds’ gains have more than compensated for the bumpy ride.”
It’s true T. Rowe Price’s active management paid off so far. For what it’s worth, Morningstar rated the T. Rowe Price Retirement series Silver, Vanguard series Gold, Fidelity Freedom Index series Bronze (Schwab Target Index series are not covered yet).
Mark A Zoril says
As a professional advisor with almost 25 years of experience, I use a Vanguard Target Date Fund. They are vastly underrated. Too many people think that it has to be more complicated than just a one fund solution.
I am in the withdrawal phase of retirement (age 76) and am considering using a TR fund for simplicity, spousal convenience in the event that I predecease her.. I have read that in the withdrawal phase of retirement that a disadvantage of a TR fund is that one is not able to select which asset to withdraw from in times of market distress(for example). This is puzzling to me since, as I understand it, the fund itself rebalances the funds on some specified schedule(monthly?, daily?)and when doing so will, by definition, be selling higher achieving funds to lower achieving funds–something an individual would have to do to keep the same asset allocation before withdrawal. Is this the case?
I am probably missing something here.
Harry Sit says
You are not missing anything. When you choose to take your withdrawal from safe assets, you will buy a less amount of distressed assets when you rebalance. When you take your withdrawal proportionally, you will sell some assets at distressed prices — the horror! — but you turn around and buy more of them when you rebalance. You come to the same end results. You can work it out with this example:
Suppose you have $50 in stocks and $50 in bonds. You need to withdraw $4. Right before you withdraw, stocks dropped 40%, bonds stayed the same. You can (A) withdraw $4 all from bonds and then rebalance; or (B) withdraw proportionally from bonds and stocks and then rebalance.
You will see under (B) the higher amount used to buy stocks in rebalancing exactly offsets the amount sold from stocks in the withdrawal.
Hi. For those that want a very simple, “don’t want to think about it” investment solution, TDFs are a great vehicle. However they do have some flaws in pre-retirement, and even more flaws in retirement. TDFs have an ever decreasing equity glidepath. There is quite a bit of research showing that in retirement, a reverse of that glidepath is a more optimal solution. Search for articles by EarlyRetirementNow (Big ERN), Wade Pfau, Michael Kitces, etc. TDFs aren’t a good solution if you have over saved significantly, it invests too conservatively.
In regard to not being able to withdraw from a specific asset class, I think that is related to a bucket strategy, whereby you have fixed income assets allocated for near term needs. In a down market, you can spend only from that bucket and not rebalance. In a sufficiently long down market, you will exhaust the bucket and then have to switch to equities. When you replenish the bucket becomes a market timing issue. Behaviorally it may make sense for some (but again, when do you replenish the fixed income), but the research I have seen indicates it is sub-optimal.
Lastly, frequent rebalancing (e.g. monthly) seems to be sub-optimal as well. It seems to be best to rebalance less frequently. Larry Swedroe suggest 25/5 (when the allocation varies 25% relative to target, or 5% absolute).
Everything my wife and I have is target date funds precisely so I don’t mess with it.
Harry Sit says
Frankie @ Fully Franked Finance says
Great perspective Harry – I have never considered an investment vehicle such as this, but couldn’t agree more with your views that not having the ability to play around and make changes is a significantly underrated advantage in any investment plan!
Scott R says
I used to use target date funds, then after joining the Bogleheads forum, I decided to mess with things myself and go heavier into stocks, but I’ve found that I’m too lazy to check on things regularly and rebalance. So maybe I should switch back to using target funds.
One thought I had a while ago for people who, like me, want a heavier stock mix would be to start by looking at what their stock/bond mix is for each target date fund, find the mix you like, and pick that one, regardless of what the date is. Any other concerns with that approach that I might not have thought of?
FWIW (and I think it’s pertinent to my heavy-stock mindset), I’m mid-40’s and I don’t really think about ever “retiring” in the traditional sense. I’m a white-collar worker (software developer) who works for a corporation, but I’m an entrepeneur at heart, and I could see myself “retiring” into a side business of my own, or working as a contractor/consultant with less hours/week when I get closer to the traditional retirement age, where I’d expect to still be bringing in a decent income.
Take a look at Vanguard. I’m 41 and I’m in the TR2040 fund. It is still 85% stock. In my TSP, where it trends away from stocks earlier, I chose one with a further out date to keep the stock mix a bit higher. But now it is just monthly deposits and forget about it.
Check out the Schwab Target Index Funds – I’m in SWYEX. It’s made up of ETFs but held in a mutual fund as one fund. It’s a great allocation strategy and net expense ratio of just .08%.
Terrific post. I am using LifeStrategy Moderate Growth for my IRA and my husband’s IRA right now for most of the reasons listed above. Right now, the Target Retirement funds are too aggressive for my “age-in-bonds” approach. However, I may switch to a Target Retirement fund as I approach retirement age and the age-appropriate fund surpasses my 40% in bonds.
Jim P says
I envy the simplicity of TD funds for me and especially as I age and for my non investment savvy spouse. Any all in one or balanced fund requires some compromise as far as overall or sub allocations.
My hesitation for the Vanguard Series is that they have made some significant changes to almost all aspects of them from overall allocation to what they invest in etc. and reserve the ability to continue to do so.
I like to know what I am buying and holding as I age into retirement- with VG owning a TD fund is like owning a slow moving active fund. Retirees often see these as set it and forget it investments only to be surprised when they find out how much international equities or bond they own or that the equity allocation has been significantly increased since they invested.
My retirement core is in Vanguard and Schwab target funds and then I use other investments to lean my portfolio directions in which I’m comfortable. I track my performance relative to these two target funds and the Morningstar average fund for the category. I also love target funds in that they’re self-rebalancing.
Jeff Bond says
Concerning Fidelity’s specific target date funds, see this link on recently increasing risk.
Harry Sit says
The Fidelity Freedom Funds highlighted in this Reuters article are not the same as the Fidelity Freedom _Index_ Funds I mentioned in the first paragraph.
Charles Ryan says
Yup, I agree for the same reason. I’ve also recommended Vanguard Life Strategy funds for retirees who appear to be overly nervous about their money. The bond portion of these funds will somewhat “mask” the volatility of the stock portions.
Having maxed our my husband’s 401K for many years, and with kids’ expenses beyond us, we are now in the process of maxing out my 403(b). With only about 6 years to retirement for me, I’m wondering if I should stick with a target date fund. Our other retirement accounts are a combination of Vanguard and Fidelity target funds.
Sam Seattle says
This is good perspective, Harry. Thanks.