For a newbie, investing can feel utterly confusing. And though there are a lot of people and institutions out there who are trying to make it easier, it doesn’t erase the fact that jargon abounds.
One of the hottest buzzwords—and investing products—in the last few years has been the target date fund. While advisors are doing a lot to make investing more accessible, it doesn’t take away from the reality that a lot of people still don’t know the answer to the question, “What are target date funds?”
A target date fund is essentially a fund of mutual funds, and the goal is to provide a calculated rate of return, that’s based on a person’s age and risk profile, usually over a long period of time. Target date funds will vary by the financial institution that is offering them, but in general, target date funds will hold a mixture of stock and bond mutual funds, among other investments.
The proportion of an investor’s money allocated to stock funds and bond funds depends on your age, as designated by your “target retirement date,” which is the year you hope to retire.
Below, we will dive into the question, “What is a target date fund” and the pros and cons of target-date funds, as well as discuss whether an investor should use a target date fund. But first, a primer on some of the investment terms that are critical to understanding target-date funds and how they function.
First—A Few Investment Basics
To answer the question, “What are target date funds,” you must first understand some basics of investing. Most notably, you need to understand what a mutual fund is.
Mutual funds were created hundreds of years ago, allowing investors to pool their money together so that they could invest in a variety of business endeavors. This “strength in numbers” effect made it possible for small investors to own many different types of investments—to achieve diversification.
It’s the same idea today—pool your money together with a bunch of strangers, and you then spread that money over a wide swath of investments. (Sometimes it is helpful to think of the word “mutual” literally.)
Investors should think of a mutual fund as a big ol’ basket of investments. Those investments could be many different types of things, but mutual funds that hold stocks or bonds (or some combination of the two) are the most commonly-used types of mutual funds, especially within retirement accounts.
Now listen up, because here’s the important part: More important than the mutual fund itself is what is inside the mutual fund. If you are invested in a stock mutual fund, you are invested in stocks. If you are invested in a bond mutual fund, you are invested in bonds.
A first step new investors should take is to learn about these underlying investment types. Then, you can decide whether they have a place in your overall investment strategy.
Stocks represent a small share of ownership in a publicly-traded company. Online stock trading comes with a degree of risk, along with the potential for growth. There are many types of risk. In the case of the stock market, this risk comes in the form of volatility, or market risk.
Bonds are an investment in the debt of a company or the government. When an investor buys a bond, they are essentially loaning out that money for a designated amount of time, in exchange for a stated rate of interest.
The money the investor earns comes from the interest paid on the bond. Therefore, bonds are considered to be an investment that is more stable than stocks, but without as much upside potential.
Generally it is recommended that investors maintain some combination of stocks and bonds. Because of the affordable, instant diversification provided by mutual funds, many investors are gravitating towards using a combination of mutual funds to fulfill their stock and bond allocations.
How much you designate towards stocks and how much towards bonds depends on your personal goals, your investing timeline, and your risk tolerance. Generally, young people with a longer investing timeframe have a higher risk tolerance and therefore have a higher allocation towards stocks. Those who are closer to retirement may want more in bonds.
A DIY investor would then purchase the mutual funds that correspond with their desired allocations. For example, if an investor wanted a portfolio of 80% stocks and 20% bonds, they could buy one or two mutual funds to fulfill each of these different investment categories.
What Are Target Date Funds?
With investment basics out of the way, we can now answer the question, “What is target date fund?”
A Target Date Fund is a fund of funds. Generally, a target date fund will hold a combination of stock funds and bond funds. The investor picks their approximate “target retirement date,” and buys the corresponding fund, which will have an appropriate mix of stock and bond funds according to their age.
For example, a 30-year-old could choose a target date fund with the year “2055” because that would correspond with a retirement age of approximately 67.
In general, a younger investor would choose a target date fund with a farther-out date. An older investor, who is closer to retirement, would choose a sooner date. This does not mean that you have to retire in that exact year. It is simply a way to gauge your age and how close you are to retirement, and therefore how aggressive or conservative your investment mix should be.
A target date fund provides three primary services:
1. You Can Buy a Ready-made Portfolio with One Click
Some investors might find the DIY approach simple, and others will find it difficult. For those that don’t want to be bothered with designing their own portfolio, a target date fund could be a suitable option. With the purchase of one fund, a target date fund provides a holistic, diversified investment portfolio.
2. Annual Rebalancing Is Done for You
Given the uneven nature of growth in the markets, one fund might grow out of proportion with the other funds. This is normal and natural. When this happens, investors should sell shares of the fund that is outperforming and re-invest in the fund that is underperforming.
This way, the portfolio maintains the desired mix of investment types. This is called rebalancing your investments, and can be done every month, quarter, year, or every few years. A target date fund takes care of all rebalancing.
3. Shifts Towards a More Conservative Allocation over Time
Personal finance experts generally recommend that investors shift their investment portfolios into a more conservative allocation the closer they get to retirement. Often, this means replacing some of the stock funds with bond funds. A target date fund builds this trajectory into the strategy, so it’s done for you.
Pros of Target Date Funds
When it comes to investing, a target date fund is pretty dang easy. Investors only need to continue buying more and more of the fund, which can be done using an automatic reinvestment function.
For small investors, mutual funds are a more cost-conscious way to invest than if they were to buy their own individual stocks. A good target date fund will pass along these savings to their investors. (Although, not all target date funds are particularly cost-friendly. See Cons, below.)
Because mutual funds are these baskets of investments, they are inherently diversified. A target date fund provides additional diversification by mixing together different asset types.
Diversification is one of the core tenets of investing, and target date funds provide that diversification in an easy, affordable way.
Cons of Target Date Funds
Not All Target Date Funds Are Created Equal
Some target date funds use index mutual funds. Other target date funds use managed mutual funds. Managed mutual funds charge higher fees and attempt to outperform the market average—and usually fail . This comes at a cost to the investor, who could have paid less to earn more via index funds.
Before you use a target date fund, take a look at its holdings. What kind of funds do you see? If they are index funds, they will quite literally say “index” in the name of the fund. And as always, if you have questions, consult a professional.
Lack of Control
Some investors won’t like a target date fund because they don’t get to control the mix of investments, when target date funds rebalance, and how quickly they shift to a more conservative allocation.
Should I Use a Target Date Fund?
If you’re looking for an easy, hands-off way to invest, a low-cost target date fund could be a great option for you. In fact, many retirement plans are now automatically participants into a Target Date Fund.
A target date fund might not be for everyone, though. For one, investors might want to reconsider a target date fund if the only option available in their 401k or at their brokerage bank is a high-cost, managed fund. Other investors might feel uneasy at the lack of investment guidance with this approach.
For investors who like the idea of using low-cost funds to invest, but would prefer access to a financial advisor, a SoFi automated investing account is a great option. SoFi offers financial advisors as complementary to the service. Best of all, you only need $100 to get started.
That way, you can have the benefits of both worlds. Investors get low-cost index funds, diversification, automatic rebalancing, and a custom mix of aggressive and conservative investment types—and an advisor that can answer questions about the investment portfolio or your financial situation.
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Diversification can help reduce some investment risk. It cannot guarantee profit or fully protect in a down market. The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. Advisory services offered through SoFi Wealth, LLC.