For years employees dreaded selecting the investments within their retirement plans at work. In an effort to address the concern that employees often did not possess the interest, expertise or a combination of the two to make informed investment decisions, lifecycle funds were born.
These funds go by multiple names, including target-date funds and age-based funds. While there are some nuances between the funds, they all perform essentially the same function and have grown in popularity to address the passive investment activities of the masses.
Target-date funds are mutual funds that are made up of investments that represent different asset classes in predetermined percentages. In many cases, the target-date funds are simply made up of a combination of other mutual funds that represent the different asset classes. Consequently, these investments should be regarded as asset allocation strategies, not stand-alone investments.
The general intent of these strategies is to help people invest in a way that maintains an asset allocation that is reasonable for that person based on key variables. Some build the portfolio solely on how much risk you feel comfortable taking. Others do it based on the number of years from a specific goal, like retirement or sending your child to college. Many base it on a combination of the two.
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When you initially invest in one of these mutual fund strategies, the assumption is that the farther away you are from the goal the more risk you can afford to take. For example, if you had two investors with the same risk tolerance and a 20-year age difference, then you could expect their recommendations to be different. In this scenario, the younger one would own a greater percentage of stocks in his portfolio than his older counterpart.
In general terms, this strategy is great for two groups of investors: those who do not understand asset allocation and those with smaller account balances. For those who do not understand asset allocation, it removes the stress of making investment decisions. Investors with smaller account balances benefit by being able to own an asset allocation strategy instead of just one or two investments that may or may not be appropriate for them.
One of the key features of these mutual fund strategies is that as you approach your goal, the portfolio managers adjust the asset allocation to one that is more conservative. These adjustments are made automatically and do not require you to initiate the changes. This feature is particularly convenient as many investors do not understand how to adjust their portfolios periodically and either do it too often, like a trader, or not often enough.
As a word of caution, some people view these as stand-alone funds and believe they need to own additional funds in order to properly diversify, as they understand the term. Keep in mind that target-date funds are simply ready-made asset allocation strategies. Therefore, if you select the one that matches your age and risk tolerance, then you do not necessarily need additional investments in that portfolio. Some investors choose to complement their target-date funds with investments that are not represented in the original strategy, such as real estate or alternative investments. However, if you choose to do this, make sure to consult the aid of a professional so that you do not unknowingly own too much of a particular asset class.
So if you know that you need to invest, but lack the expertise or interest to develop an asset allocation strategy that is appropriate for you, then take a second look at the target-date funds within your retirement and college savings accounts. After all, these goals are too important for you not to have a sound strategy to help you along the way.
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