These days, retirement investing is beginning to resemble a game of horseshoes. Close enough is often considered good if the distance to where you want to be and where your investments are is not too far off. But horseshoes, when played by yourself, is just practice. And when you think close enough is good enough, as Morningstar recently suggested in a recent look at target date funds, you will be sadly disappointed.
Retirement is not a game of horseshoes.
Maybe not, yet it is, often seemed as too difficult, perhaps too hard for some folks to grasp. The concept, as I have mentioned here hundreds of times in the past, relies on three basic factors: one investing at least 5%, increasing that investment incrementally by one percentage point each year thereafter, and while this is going on, get your financial house in order.
It is well know that Americans simply do not put enough money away for their future. And because of that, target date funds (an investment that allows the mutual fund manager to adjust the holdings of the fund as time progresses towards a target date sometime in the future) have become the default investment of new hires and the darlings of those investors who claim to lack investment skills.
We Fear the Future because of the Past
After the 2008 investment season and early into 2009, there were only a handful of investors who could claim to have these elusive skills. As far back as Benjamin Graham, the skill that was needed to be a successful investor was widely believed to be a possession of the few. It wasn’t necessarily the wealthy either. But a subset of the populace who, for some reason, understood the mechanism better than others.
Successful investing could actually be a mathematical skill or perhaps and emotional detachment from the process. But most of us lack more than basic math and as to the detachment, we are too emotionally involved with the investment world – even if we choose an auto-pilot investment like target date funds.
By choosing to set aside 5% (employer match or not) in your 401(k), the most common type of defined contribution plan, you begin a process that is both rewarding and risky, comforting and scary, smart and random. That 5% should be allocated across a minimum of three funds, all actively managed (as opposed to index funds which are passively managed) and invested across the broadest measure of the market.
Each additional 1% added in each successive year would add more funds to your portfolio, further broadening your horizons. If you begin with a large-cap, mid-cap, or small-cap grouping right out of the gate (“cap” refers to the market capitalization of the companies within the fund), adding an international fund, then an emerging market fund as your contribution levels increase is the best next steps to take in the process.
And if you reach the point where you are actually investing 7% of your pre-tax income in those five funds, you can begin to add a more conservative fund to the group. And for most of us, this will be all you need for the first fifteen years.
Now for the questions.
Why not index funds? These are tax efficient and if you want to own them, do so after you get your financial house in order. Most people do not realize that index funds do not own all of the companies in their fund – this is particularly true the smaller the companies in the index. Index funds readjust every year, selling losers and buying winners. Even first time investors know this isn’t the right thing to do.
What if index funds are all that is available in my 401(k)? Then work with what you have and take the same allocation path. Then ask your plan administrator to add some variety to the plan.
What is it about target date funds that makes them the focus of so much criticism? They can’t convince me that the fund managers who are running them know what they are doing. There is no long-term track record (short-term, they are losing ground) and even there was, it wouldn’t really matter. It would be far less than what you would have made had you simply invested on your own. Another thing: they can be dumping grounds for lackluster funds in the fund family giving you the impression that these funds are diversified.
Once again, allow someone else to do something that you could do as well -even if their execution is seemingly good – is not worth the risk. Target date funds, if this were a game of horseshoes, would be throwing their shoe at a peg much farther away. yes, retirement is far away. But it is the steps you take each year that get you closer.
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