Six Ways Target Date Funds Simplify Investing
Investing is simple, but it’s not easy. No matter where you are in your savings journey, you probably know that a lack of diligence and poor investment decisions can lead to a major financial setback. That’s why having a disciplined process is crucial to growing your savings quickly and increases your chances of achieving investing success.
What can you do if you don’t have the time or inclination to follow an investment management process, or are just looking for a prudent and straightforward way to invest your savings? Consider using a target-date fund. These investment vehicles can help you gain diversified market exposure, reduce the amount of time you spend on selecting and managing investments, and enable you to focus your efforts on improving your savings discipline.
1. Set Up for Long-Term Investing Success
Diversification is at the heart of a prudent, long-term investment strategy. Diversification — the process of spreading your savings across multiple investments — can reduce your chance of financial loss, especially as it relates to firm-specific risks.
For example, over 20,000 U.S. companies filed for bankruptcy protection in 2019. Given the current economic environment, this number is expected to grow in 2020. As an investor, this point about bankruptcies is critical because equity holders are often the first to take losses during a bankruptcy restructuring. If your investments are concentrated in a single company, there is a risk that one bad year could lead to a catastrophic loss in your portfolio. Consider what happened with Enron nearly two decades ago.
Until the early 2000s, this major energy company and Wall Street darling saw a boom in its stock price. It was revealed in 2001, however, that company executives were involved in an elaborate accounting scandal. Not only did the firm mislead investors, but the actions also led to the company’s eventual bankruptcy.
From its peak of $90 per share in 2000, Enron’s stock essentially became worthless in a matter of months. This example drives home the point that diversifying your investments across many companies and industries can reduce the risk that one unfortunate event won’t wipe out your entire savings.
Smooth out returns
Diversification can help smooth out investment returns. Few individuals can predict with certainty which investments will perform well in any given year. In fact, history has shown that an outperforming sector or asset class one year often loses favor with market participants the following year.
Rather than guess which investment might do well from one year to the next, diversifying your portfolio lets you gain exposure to market returns without having to pick at a winner. When paired up with assets of varying correlations, diversification has historically shown an ability to reduce volatility and smooth out portfolio returns.
Given their structure as a fund of funds, target-date funds implicitly offer diversification benefits from the start. These investment vehicles diversify holdings across many different funds. They often spread risk exposures out across U.S. and international holdings, different asset classes like stocks and bonds and sectors, and styles like growth versus value. To be sure, diversification is at the heart of target-date funds. This element is crucial to reducing company-specific risks, smoothing out returns, and achieving long-term investment success.
2. Simplifies Asset Allocation Decisions
Having a mix of securities in your investment portfolio is a good start. But how do you know that your expected returns make sense for the amount of risk that you’re taking? Moreover, how do you know that your portfolio’s construction aligns with your overall investment objective? That’s where asset allocation decisions come in.
Asset allocation involves finding an optimal mix of investments with the intent of maximizing portfolio returns while minimizing risk. These decisions are based on several complex factors, like expectations of future investment returns and correlations between one or more assets in your portfolio.
Asset allocation also introduces certain constraints within the portfolio. For example, a conservative investment objective might give more weight to less-risky investments, like bonds. Investment objectives with higher tolerances for risk, on the other hand, might bias the asset allocation decision toward riskier investments like stocks. Target date funds utilize asset allocation models and adjust their weightings based on an individual’s investment time horizon.
For example, if you intend to let your money grow for 20 years, then a target-date fund likely will have greater exposure to equities than bonds with a focus on capital appreciation. As you move closer to your investment goal over time, a given target date fund will periodically rebalance to include a higher allocation to bonds with a focus on capital preservation and income generation. Target date funds not only help you diversify your investments but also simplify asset allocation related decisions.
3. Takes the Guesswork Out of Choosing the Right Security
Investing in individual stocks and bonds is a practice that requires skill and time. In the U.S. there are well over 5,000 companies listed on stock exchanges. To be a successful long-term investor, you’ll have to know 1) which of these companies are a going concern, 2) whether they can continue to generate earnings in a given economic environment, and 3) whether they can provide an adequate return on investment. Then there are valuation factors to consider, like whether the security is cheap, fairly valued, or expensive relative to market and other crucial concerns.
Professional money managers spend their day sifting through company financials and consider factors like valuations and economic fundamentals to identify investment opportunities appropriate for their given portfolios. Quite often, the tools and data used in these processes are not readily available to individual investors. These managers also spend their time staying on top of industry and market developments and adjust their portfolio holdings as market and economic conditions warrant.
The point here is that managing an investment portfolio is, in some cases, a full-time job. Because they are professionally managed vehicles, target-date funds help take the time and guesswork out of choosing appropriate securities for your investment portfolio. This is important because professional money management lets you focus on handling other aspects of your finances and frees up your time to pursue what’s essential in life.
4. Takes the Emotion Out of Investing
Investing is not for the faint of heart. Risks are ever-present in financial markets. And one wrong, emotionally based decision can lead to a significant loss of savings. For example, in March of this year, some investors, worrying about the coronavirus’s effects, liquidated their portfolios, hoping to avoid a market crash. In just a few short weeks, however, the prospect of fiscal and monetary policy led to a rip-roaring boom in U.S. equity markets.
If you had sold off your portfolio at the March lows, you’re likely to have experienced investment underperformed this year. Even if you reinvested in the markets one week after the low and participated in the market rally, you would probably have suffered returns lower than otherwise remaining fully invested.
Knowing when to trim back exposure or stay fully invested is part of a disciplined investment process. Even so, there may be times where the possibility of a loss to your savings might fuel emotions that lead you to act within your portfolio at an inopportune time. Having a steady, objective hand on the wheel can help ensure that you achieve essential investment goals.
Because target-date funds are professionally managed, ebbs and flows in economic and financial conditions are one less thing that you need to be concerned about. Moreover, knowing that your portfolio will be professionally rebalanced when necessary can help you stay focused on growing your investments for the long-term, rather than worrying about short-term developments in the economy and markets.
5. Simplifies Portfolio Management
Investors are often encouraged to “buy-and-hold” an investment for the long-term. When managing a portfolio of individual securities, however, there are often risk management factors to consider. Periodic rebalancing is a vital issue to recognize. Rebalancing is crucial to the investment management process because allowing your portfolio to drift from its target allocation can expose your savings to unnecessary risks.
How does rebalancing work? Well, rebalancing takes advantage of the long-term effects of mean reversion in the financial markets. More simply, asset prices tend to move lower after a strong market rally and higher after a sharp market selloff. Therefore, the intent of rebalancing is to realign your portfolio with its target allocation following market swings. This is done by using recent market strength to trims gains and reallocates those funds to underperforming assets in your portfolio.
Knowing when and how much to rebalance is one challenge of the investment management process. A target-date fund, however, simplifies the process by performing rebalancing on your behalf. This rebalancing is done by target date fund managers, making it one less step in the investment management process to worry about.
6. Gives You Time to Focus on Compounding Growth
If you’re looking to invest a modest amount of money, a target-date fund can help you gain diversified market exposure right from the start. Trying to build a diversified portfolio on a limited budget can be a challenge. This is particularly so when a stock’s price can average between $20 and $30 per share or given that a bond’s price sometimes starts around $1,000 per note.
Target date funds, on the other hand, generally have initial minimums of $1,000 and allow for investment contributions of as low as $50 at a time. Given these low dollar thresholds, target-date funds enable you to gain exposure to a broadly diversified portfolio no matter what your budgetary constraints. This can help by allowing you to spend less time searching for securities, and more time focused on supercharging your investments by increasing your savings rate and letting the power of compounding make your money work for you.
For example, let’s assume that you invest $100,000 into a target-date fund that returns 5% per year, and you contribute $100 per month. At the end of 20 years, your initial investment plus contributions would grow your savings to $312,000. Let’s take this example one step further and assume that you decide to supercharge your savings by finding ways to increase your contributions by $100 per month every year for 20 years. What difference would this make?
Over 20 years, your regular contributions would steadily rise from $100 to $2000 per month. At this elevated savings contribution rate, your investment portfolio could grow to well over $600,000 in 20 years. That’s more than double the projected rate of adding a fixed $100 per month over the same time.
These illustrations are intended to drive home the point that seemingly small changes in your savings behavior, combined with a little time and a modest rate of return, can lead to significant wealth generation. When you’re starting off on your investing journey, a target-date fund can help you stay focused on optimizing your personal finances and supercharging your investment growth through compounding.
Target Date Funds Can Simplify Your Investing Experience
Whether you’re new to investing or have managed a portfolio for years, having and adhering to a disciplined investment process is crucial to achieving your financial goals. A disciplined investment process includes selecting securities appropriate for your unique situation, determining how much to own, and deciding when to buy, sell, or hold.
If you have neither the time, inclination, or resources to develop a disciplined process, then a target-date fund is one way to simplify investing. These investment vehicles can help you gain diversified market exposure, reduce the amount of time you spend on selecting and managing investments, and enable you to focus your efforts on improving your savings discipline.