Portfolio Management 101 > Asset Allocation

Who Should Use Target Date Funds?

Target Date Funds

The use of target date funds in 401K plans is growing rapidly, particularly now that employees are automatically enrolled in their employer’s 401K plans upon joining the firm. If an employee doesn’t want to participate, they have to opt out, unlike in years past, when you had to actually sign up to contribute.

The rule is a good one because most people don’t put enough away for retirement and getting people to sign up is extremely challenging. By the same token, people who are automatically enrolled tend not to make the effort to opt out. The problem is that most people who contribute to a 401K have no idea what to invest it in. And even if they received some sort of guidance from the plan provider, there is usually no follow up to ensure the portfolios are rebalanced and certainly no guidance on potential changes to investments due to changes in an employee’s situation. Enter the often misunderstood target date fund.

A target date fund is designed to be a single fund solution for investors with neither the time, expertise, or desire to spend time managing their investments. The concept is quite simple: A target date fund is designed to provide a dynamic asset allocation depending on the expected retirement date of a particular investor, investing more conservatively as the ‘target date’ approaches. For example, an investor expected to retire in 2045 would still have over 30 years of income generation.

A target date fund for 2045 would most likely be heavily invested in equities, as the diagram below indicates. As the year of intended retirement approaches, the exposure to equity diminishes. For example, the 2015 fund, which is intended for someone about to retire, only has approximately 35% in equities, therefore diminishing the risk of

Target date allocations

the portfolio as the time to begin withdrawals draws near.

Target date funds can include a variety of asset classes such as US equities, international equities, emerging market equities, sovereign fixed income, corporate fixed income, high yield, emerging market debt, commodities, real estate, currencies, etc.  They are great tools for portfolios whether in or out of 401K plans but they are not for everyone. Who should invest in target date funds? The inexperienced – if you don’t have much experience investing, you are better off choosing a target date fund.  Just set it and forget it.

Unless you develop enough investment experience and are willing to periodically (quarterly)evaluate your investments, this is the way to go. The time constrained – while managing a portfolio of mutual funds does not entail the same level of diligence required to invest in individual stocks, investing still requires periodic monitoring of your portfolio and rebalancing when necessary. If you don’t have the time to periodically monitor your portfolio, including being well informed about economic and capital markets, invest in a target date fund. The disinterested – and I don’t mean that in a critical way.

I’m referring to people that may have some experience with investments and can afford to spend some time on them, but choose to do something else entirely. If you meet any or all of these criteria, you should seriously consider investing in a target date fund. If, on the other hand, you are the opposite, you may want to consider developing your own asset allocation and tactically managing your portfolio as you see fit. For additional guidance, read Asset Allocation, Core Satellite Investing, and Active vs. Passive Investing.

You may also want to consider the following books:

Fiduciary Handbook for Understanding and Selecting Target Date Funds: It’s All About the Beneficiaries, by Ron Surz

Investing for Retirement, by Virginia Morris

A Beginners Guide to Investing: How to Grow Your Money the Smart and Easy Way, by Alex H. Frey


Asset Allocation

Asset allocation is the process of assigning a percentage of a portfolio to each asset class in an attempt to maximize the risk-adjusted return of a portfolio for a given investment profile. An asset allocation serves as the overall strategy for a portfolio and guides the amounts to allocate to each asset class, such as US Large Cap Equities, Small Cap Equities, High Yield Fixed Income, and alternatives, such as Real Estate. Each of these asset classes and/or additional asset classes is assigned a percentage that when taken together, coincides with your investment objectives and risk tolerance.

It’s a New Year, Reflect and Rebalance

Portfolio Rebalancing Rocks

It’s the beginning of a new year and many of us find ourselves reflecting on the year gone by, thinking about both our accomplishments and failures. The list of New Year’s resolutions created just one year ago has been long forgotten and replaced with a new list, equally as ambitious as the previous list and receiving an inordinate amount of our attention for at least the next 3-4 months. After that, it’s back to life and business as usual.

For investors who added to their equity positions this year, this is a good time to pat yourself on the back and enjoy one of the best returns we’ve had in the US equity market in quite a while. The S&P 500, as measured by the iShares S&P 500 Index ETF (SPY) had a return of 32.31% according to Morningstar.com. For bond investors, unfortunately, 2013 was the end of a multi-year party. The iShares Core Total Aggregate US Bond ETF (AGG) had a return of -2.02%, after having gained 4.21%, 7.84%, 6.54%, and 5.93% for 2012, 2011, 2010, and 2009 respectively.

Looking forward to 2014, most forecasts predict positive returns for equities once again but with actual returns being closer to 10%, not 30%. In other words, don’t expect a repeat of 2013. For bonds, the prognosis continues to be a very challenging environment as interest rates creep up, with the eventual benefit of finally being able to invest in a fixed income security with a yield above that of inflation. At least until the rate of long anticipated inflation begins to pick up.

As for new year’s resolutions and your investment portfolio, if you do nothing else the least you should do is rebalance. Rebalance your equities back down to the appropriate level and increase your fixed income to its long-term strategic allocation. This may sound counterintuitive in light of the forecasts we just provided. You may be wondering why we are suggesting to reduce equities, when we just mentioned that equities should perform well. Looking at it another way, if you sell the portion that increased and buy more of the portion that decreased you are essentially buying low and selling high. Too many investors do the opposite, chasing returns by adding to those asset classes that have recently performed well and selling asset classes that have performed poorly. Don’t fall into that trap! Be more like the institutional investors that David Swensen discusses in his book, Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment.

Buying Low and Selling High

This past year, the value of the equity portion of your portfolio has increased considerably depending on how that portion of your portfolio was invested. Assuming it was invested entirely in US Equities through the iShares S&P 500 Index ETF, that portion of your portfolio would have grown by 32.45%. Meanwhile, the portion of your portfolio invested in fixed income, assuming exposure to fixed income through AGG, that portion of your portfolio decreased slightly. The resulting weighting of your portfolio is now overweight to equities compared to how it was allocated at the beginning of 2013. We’ll explain.

Let’s assume you have a $100K portfolio, of which 60% was invested in SPY, and 40% was invested bonds through AGG. Lets further assume that this 60/40 split is consistent with your investor profile and risk tolerance. (For more information on your Investor Profile, take our quiz). At the end of 2013, the equity portion of your portfolio would have grown from $60,000 to $79,386, while your fixed income portion would have decreased to $39,192, from the original $40,000. If you refer to the table below, you will notice that the new percentage allocations are 67% for equities and only 33% for fixed income.

Effect of Returns on Asset Allocation


This is now a more aggressive portfolio than that which you started with and is also much riskier. A big mistake would be to leave the portfolio as is and a bigger mistake would be to add more to equities. In order to maintain the portfolio at the same risk level as the 60/40 original portfolio, you would sell $8,239 worth of equities (at a higher level than you started) and reinvest the proceeds into fixed income (at a lower level than where you started), as shown below. Buy low, sell high, resulting in the a new portfolio with the original 60/40 allocation.

Rebalancing back to 60/40




Discipline and Frequency

By doing this on a regular basis, you ensure that your portfolio reflects your individual investment preferences and risk tolerances and ensures that you do not take unnecessary risks inadvertently. Too often investors do not adjust portfolios and the equity portion continues to become a larger part of the portfolio until there is a big correction in the markets that result in massive losses. This was a common occurrence during the equity market meltdown in 2008.

We recommend that portfolio rebalancing occurs quarterly but we also recognize that sometimes the percentages do not move much over such a short period. That is why it is so important to make sure that portfolios are rebalanced at least annually, and what better time to do this than either late in the year (for possible tax benefits), or the beginning of the new year.

So as you are preparing your list of new year’s resolutions make sure that portfolio rebalancing is at the top of the list. It does not take long and once done, you can check it off your list and forget about it for the rest of the year – if you prefer.