With target-date funds, you should put all your eggs in one basket

A relatively new invention in the mutual fund universe is the target-date fund. These are funds intended to be "all-in-one" options that allocate assets based on the year you plan to retire. For example, if you intend to retire in 2040, you'd simply put assets into a 2040 target-date fund. The closer a fund gets to its target date, the more conservative its asset allocation becomes.

Recent legislation and regulatory inducements set up to sign people up automatically for 401(k)s also included inducements to include target-date funds as the primary choice for the automatic investments. Right now, only about 7% of 401(k)s are invested in target-date funds, but the Employee Benefit Research Institute found a disturbing trend in how these funds are being used.
About 55% of the participants holding target-date funds are mixing them with other mutual funds, which could result in an "inferior portfolio in terms of risk/return trade-off from more assets allocated to some sectors than the designers of the target date funds planned," according to the EBRI study. More than half of the investors mixing it up do so because they don't want to put all their eggs in one basket. Others said they mixed up target-date funds because they weren't sure when they wanted to retire.

Not putting all your eggs in one basket is a good basic strategy for most investments, but it's a strategy that doesn't work with target-date funds. If you choose to use a target-date fund, you're choosing to have a professional allocate your assets appropriately based on your target retirement date. By adding additional assets to the mix, you may actually be hurting your chances of meeting your retirement goals by taking on higher risk or getting lower returns than a properly allocated portfolio would provide. When it comes to target-date funds, it's an all-in or all-out proposition.

Properly Allocated Funds Have Ups and Downs Too

Are target-date funds worth it? Many investors didn't think so after target-date mutual funds recorded big losses last year. In fact shareholders complained to Congress and called for increased regulation. Some financial advisers deemed target-date funds a failed experiment. But as markets recovered, the target-date funds outpaced the S&P 500, primarily because they held large portions of their portfolios in foreign stocks.

Much of the underperformance in 2008 can be attributed to big stakes in foreign stocks. Target 2040 portfolios currently have 27% of assets in overseas stocks, and 2010 funds have 13% abroad, according to Morningstar. In 2008, foreign stocks trailed U.S. stocks: While the S&P 500 lost 37% of its value, European funds dropped 49%, and diversified emerging-market funds declined 54%, according to Morningstar. But in 2009, foreign stocks came back much faster than U.S. stocks. For example, target 2040 funds returned 30% this year, outdoing the S&P 500 by 5 percentage points.

With a properly allocated portfolio, everyone will have good and bad years. After the market crashed, it was a bad year for just about everyone. The key is allocating the portfolio for a quick comeback, which target-date funds proved they can do.

While target-date funds aren't for everyone, they do provide a good option for people who know nothing about investing and would prefer to have someone else manage their assets. If you prefer to manage your own portfolio, then do so. But don't mix a target-date portfolio with your own choices. Either take responsibility for portfolio management or choose someone to do it for you. If you decide you do want a target-date fund, then research your best option and dive in, but know it's not a good idea to dive in part of the way.

Lita Epstein has written more than 25 books including, Trading for Dummies and The Complete Idiot's Guide to Value Investing.
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