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2 Common Ways to Misuse Target Date Funds
October 8, 2015
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Do you know much about vitamins? Do you know the difference between vitamin B and vitamin B-12? What’s the significance of the “12″? How about Vitamin S?

That last one was a trick question. Vitamin S is a musical group in New Zealand.

You are probably wondering why I feel compelled to discuss vitamins in what should be a column devoted to investments. Don’t worry, I will reveal all in just a minute, I promise. But first, a confession.

I know nothing about vitamins. Which is fine, because I take a multivitamin that makes it all easy. Not only does it blend a bunch of vitamins together, it’s also formulated for adult males over 50 (yes, that’s shockingly old!). Fortunately, the vitamin industry has made it easy for people like me who just don’t want to spend time learning a lot about vitamins.

From Your Medicine Cabinet to Your Portfolio

For many of us, the world of individual asset classes is equally complicated. Small cap growth? Intermediate bonds? Emerging market stocks? How much should you take of each? And should you take different amounts of each based on your age? Would the idea of an investment ‘multivitamin’ that would give you your recommended daily allowance of mid-cap equities and other asset classes be attractive?

There is a multivitamin equivalent of sorts for investors. It gives you a dose of the essential asset classes allocated based on your investment horizon. It’s called a target date fund. What’s nice is that it’s actually better than a multivitamin: It automatically adjusts its mix of investments over time as you age. If you haven’t heard of these, look no further than the closest 401(k) plan, where they have quickly become the default option of choice for many plans.

Two Common Target Date Fund Mistakes

I like to think that target date funds seem pretty simple to use, but maybe that’s because of what I do for a living. Anyway, I’m always surprised by surveys that uncover investment patterns showing target date fund misunderstanding. So let’s explore some of the common mistakes people make with target date funds, and then for fun take a look at the equivalent misuse in the vitamin world to help you think about ways to best leverage this strategy.

Mistake #1: Multiple target date funds

Some participants, remembering the old adage about not putting all their eggs in one basket, assume it’s better to spread their money out between multiple target date funds aimed at different retirement dates. Although they are different funds, most target date funds for different ages have the same underlying investments, but with slightly different weights. So investing in different funds doesn’t, in fact, provide greater diversification. In the vitamin world, this would be like taking a multivitamin for teenagers, another for middle-aged people, and a third for those over 60.

Mistake #2: Investing Only a Fraction of Your Portfolio in a TDF

Sometimes I call this the “toe-in-the-water” approach. Although there are probably many justifications, it probably boils down to a lack of trust. The vitamin equivalent might be taking a multivitamin on the weekend, and then mixing your own concoction during the week. My feeling is: Either do one or the other—at least with your 401(k). It may defeat the target date fund’s engineering to supplement it with other asset classes. Or, if you really do feel that you have unique investment needs, you may be better off using a managed account or advice provider to build a custom portfolio.

Target date funds (and multivitamins) may be the right solutions for those of us who don’t feel compelled to learn all about a particular discipline and so would rather rely on a professionally selected blend. Multivitamins are just one example.

Although this analogy was intended to help explain target date funds, it also surfaced a novel product idea: a vitamin for those born in a specific decade that changes its blend over time. You would never have to make that awkward transition from “young and active” to “middle aged and sedentary.” Although I probably won’t pursue this idea, if you do, I would be completely happy with a 10 percent royalty.

 

Scott Dingwell is a Director in BlackRock’s Global Client Group where he serves on the U.S. and Canada Defined Contribution Team. He writes about retirement for The Blog.

Investing in target date funds involves risk, including possible loss of principal. The target date in the name of the funds is the approximate date when an investor plans to start withdrawing money. The blend of investments in each portfolio are determined by an asset allocation process that seeks to maximize assets based on an investor’s investment time horizon and tolerance for risk. Typically, the strategic asset mix in each portfolio systematically rebalances at varying intervals and becomes more conservative (less equity exposure) over time as investors move closer to the target date. The principal value of a fund is not guaranteed at any time, including at and after the target date.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

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Source: BlackRock Blog Retirement
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