Target-date funds are designed as one-stop shopping for retirement savers. A participant in a defined-contribution plan needs to make just one selection, or can even be defaulted into a fund based on his or her age, which grows more conservative as that date approaches. It works well for savers who don’t know a lot about investing and/or don’t want to pay much attention to their portfolio. However, a growing number of participants allocate assets to other investment options in addition to the target-date fund. These folks are commonly referred to as “mixed” investors.
While pairing the target-date fund with other investments might seem like a harmless exercise, or even a prudent one, it’s usually a bad (and sometimes terrible) idea. It’s a bit like throwing a few extra eggs into the recipe for making a cake. It might seem like a positive, but it can have a significant negative impact on the outcome.
Target-date funds allow the investor to totally offload investment decision making to professionals or even to an algorithm. A large body of research suggests this is likely the smartest thing because most investors aren’t very good at it. Compared to investors without target-date funds, mixed investors may be more prone to market-timing, a strategy that has consistently proven detrimental.
I’ve found in recent research that the majority of mixed investors are buying equity funds to compensate for a less-aggressive target-date fund. For example, among mixed investors, 43% of the portfolio was in the target-date fund, 42% in equity funds and 11% in bond funds, on average, according to my analysis.
Why do so many investors mix other investments with target-date funds? There are probably myriad reasons. One may be that target-date funds show up as a single investment on the plan website or quarterly statement, similar to other options like stock or bond funds. From this perspective, they look like a “black box” and an investor may feel he or she needs to include other funds to diversify. In reality, that move could have the opposite effect, by reducing the efficiency of the portfolio.
If the goal is a more aggressive allocation, the answer can be found within the target-date fund structure itself simply by selecting a vintage (or year) with a later retirement date. For example, an investor who plans to retire in 2025 but who doesn’t like the typical 55% equity allocation could instead select the 2050 vintage, where the equity tends to be closer to 85% (or even go out to the 2060 fund where the average equity allocation is 90%). While actual equity allocations vary by provider, I believe moving along the glide path to target a given risk level is much smarter than mixing the target-date fund with other investments. I would argue that while holding multiple funds with different target dates might be a bit off, it’s still better than combining target-date funds with other investments.
Target-date funds aren’t perfect since they aren’t personalized to each investor. But they are definitely an improvement over an inexperienced investor’s random notions for building a portfolio. To dial risk up or down, investors may want to consider pushing the timeline. But in my opinion, target-date funds serve investors best when they are the only cook in the kitchen.
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