Keep Your Eye on the Prize With a Target Date Fund

The stock market’s steady decline over the past six months has taken few prisoners. Energy and utility stocks are up. All of the other nine sectors that comprise the S&P 500 Index are down, most by a lot.

That has everyone on edge, including young investors for whom the current correction will be but a distant memory by the time they retire. Even still, it is difficult for them to resist the temptation to abandon stocks and stop the bleeding.

Last week, my son asked me for advice regarding his 401k account. He is gainfully employed and is contributing the annual maximum to his retirement account.

He is also smart enough to realize that when it comes to investing in the stock market, a little knowledge can be dangerous. Instead, he would prefer that someone else make those decisions for him.

For that reason, he asked me if it would be wise for him to put all of his 401k balance into a target date fund (TDF). The concept behind a TDF is simple. As you get older (and closer to retirement), the portfolio becomes more conservative.

A TDF is a “fund of funds”, comprised of several mutual funds that own stocks, bonds, and other asset classes. For example, the Vanguard Target Retirement 2050 Fund (VFIFX) currently owns the following funds:

  • Vanguard Total Stock Market Index (VTSMX) – 53.4%
  • Vanguard Total International Stock Index Fund (VGTSX) – 36.6%
  • Vanguard Total Bond Market II Index Fund (VTBIX) – 6.9%
  • Vanguard Total International Bond II Index Fund (VTIIX) – 3.1%

Stick to the Plan

As you can see, this portfolio consists of 90% stocks and 10% bonds. And since we are still a long way from the target date year of 2050, the portfolio allocation will probably remain that way for a long time.

That is both good news and bad news. The bad news is that when the stock market goes through a major correction, this portfolio will almost fully participate.

The good news is that when the correction is over and the stock market rallies, this portfolio will almost fully participate in that, too. And since the rallies are almost always bigger than the corrections, in the long run this type of portfolio should do quite well.

Even still, in the short run it can be difficult to ignore a declining 401k balance. Had you chosen to contribute less to your 401k, more of your hard-earned pay would have ended up as cash in your bank account.

However, that reasoning ignores two critical benefits of a 401k plan that are not immediately apparent. Your contributions are tax-deductible so more money is being invested there than would have landed in your bank account after income taxes and other deductions have been withheld.

Also, the shares you are buying now are cheaper than they would have been if the stock market never dropped in the first place. Later on after the stock market has recovered, the return on those shares will be greater than for the shares you bought six months ago at a higher price.

For all those reasons, I advised my son to stick to his plan. If he contributes the annual maximum every year until 2050 and lets the target date fund do its thing, he should be able to retire in comfort.

Take a Global Perspective

All that said, a TDF is not designed to outperform the overall stock market. Over the past 10 years, VFIFX has delivered a total return of 166% compared to a 279% gain by the SPDR S&P 500 ETF Trust (SPY).

That discrepancy is mostly due to the degree to which domestic equities have outperformed foreign stocks over the past decade. However, the next 10 years could be quite different.

Last week, I explained why investing in India now could prove to be a smart move by the end of this decade. For similar reasons, there are several other countries that could outperform the U.S. stock market over the next 10 years.

That is one more reason why using a target date fund in your retirement account may be a good idea. But if you need to outperform the overall stock market to reach your long-term goals, then a TDF may not be the best choice for you.

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