Should I Invest in Target Date Funds?

Maybe I just paid more attention this time than I did seven years ago, but the hype behind this week’s total solar eclipse seemed a bit excessive. The sun goes away every day for ~11-12 hours, so who cares if it does it for 4 minutes in the middle of the day? Off my soapbox.

Maybe, but there’s a better way to invest for retirement.

If you’ve been around for a while, you might remember Wilson briefly talking about target date funds (TDFs) during this newsletter. I hope you like acronyms, because you’re about to read TDF about a hundred times.

Simply put, TDFs are a type of mutual fund that hold a collection of various securities (but primarily stocks and bonds) and are based on a selected retirement date. Most major brokerages offer TDFs in 5-year increments (2025, 2030, 2035, etc.) for different retirees. A 25-year-old in 2024 planning to retire at age 65 could invest in a target date 2065 fund (since there is no TDF for 2064).

Here’s the fun part. TDFs automatically and gradually shift more of your asset allocation from stocks to bonds as you approach your selected retirement year to better protect your portfolio from stock market crashes closer to retirement.

For my visual learners out there, here’s a highly technical depiction of how TDFs change over time.

The further you are from your target retirement date, the more aggressive and growth-focused the asset allocation is (holding more stocks than bonds). As you get closer, your allocation becomes more conservative, introducing more bonds to decrease your portfolio’s volatility before and during retirement.

TDFs do the work of rebalancing for you. They truly are the simplest investment option. But are they the ultimate life hack for stock market investing?

They can be good, but not great. Let’s look at both sides.

Pros

Like I mentioned before, they’re stupid simple and effortless (for the investor). A single fund run by a posse of finance nerds can do the hard work of managing your stock/bond allocation from now through the time you croak.

Best of all, they help investors overcome analysis paralysis. It can be intimidating trying to figure out the right balance of stocks and bonds throughout your investment horizon. TDFs can give you the confidence to pull the trigger and start investing.

They take thinking out of the equation when investing, limiting the potential for you (and I) to make insane financial decisions or no decision at all.

Cons

I find TDFs to be relatively rigid and highly conservative.

Vanguard’s Target Retirement 2025 Fund (VTTVX) is made up of roughly 53% stocks and 47% bonds. For investors with lower planned retirement withdrawal rates or shorter retirements, a nearly 50/50 split may be sufficient to make your money last. But you can probably do better.

If you recall the fancy asset allocation chart from a previous letter, a 75% stock and 25% bond allocation has historically had a better success rate than a 50/50 split over every retirement horizon and withdrawal rate. And 100% stock allocations outperformed both almost every time.

Those who plan for a longer retirement need a higher stock allocation. This ensures your investments continue to grow (or decrease slowly) while you sell a certain percentage each year to cover your expenses.

Even Vanguard’s Target Retirement 2065 Fund (VLXVX), designed for those retiring in 41 years, is too conservative (in my opinion), holding 89% stocks and 11% bonds. Unless you’re spooked out of the market easily, someone 40 years from retirement has no business touching bonds.

If you insist on investing in TDFs but want to increase your money’s growth potential, you can invest in TDF with a later date than your actual planned retirement date to maintain a more aggressive portfolio for longer. Like a 2045 retiree investing in a target date 2065 fund.

Also, TDFs tend to have higher expense ratios than index funds or bond funds do. VTTVX currently has an expense ratio of 0.08%, double that of Vanguard's total stock market index fund (VTSAX).

My final take on TDFs: meh.

They're better than an actively managed mutual fund when it comes to fees, but they don't meet the individual investor's specific needs. And for this reason, it’s probably best to avoid them.

You can accomplish the same thing with a better chance of higher overall returns through investing in index and bond funds.

Since WWII, the average correction (10% market decline) recovered in four months and the average bear market (20% market decline) took two years to recover. If you increase your bond portfolio two to five years from retirement, you could protect your portfolio from (most) market downturns while giving your stock portfolio the most time to grow.

However, if your options are between investing in a target-date fund or not investing at all due to decision paralysis or whatever other reason, choose a target-date fund.

“Action is the foundational key to all success.” - Pablo Picasso (- Michael Scott)

Call to Action

Tax season ends April 15th! If you’ve been procrastinating on filing your taxes, be brave and (hopefully) you won’t owe any extra money to Uncle Sam.

What We’re Reading/Listening To:

The $100 Startup by Chris Guillebeau. Starting a business doesn’t have to take hundreds of hours or thousands of dollars. Even if you plan on keeping your day job, diversifying your income sources can provide you additional financial security.

Debrief on Deck

Next week, Wilson will talk about how to buy bonds directly from the Fed. I’ve never done it myself, but apparently it’s much easier than you’d think. He obviously didn’t ask me first, because I would have said he has no business touching bonds.

As always, please reach out to us with any questions or comments you have. You can reply directly to this email or find us on social media (X (formerly Twitter) and Instagram).

Until then, stay the course.

Disclaimer