Selecting suitable investments is key to achieving your financial goals. But this is only one piece of the puzzle. In addition, you need to pay attention to the diversification of your overall portfolio and your asset allocation. These two elements have a significant impact on the overall risk of your portfolio.
The benefits of holding a diverse collection of assets are tied to how the investments are correlated. According to modern portfolio theory (MPT), investors can maximize their return potential and reduce the risk of losses by combining investments in asset classes that are not perfectly correlated with one another, i.e., their performance does not move in tandem. Moreover, a combination of investments such as this is likely to do reasonably well in various economic and market environments, because as one asset is falling, another is likely rising.
Using the My Portfolio tool of A+ Investor, you can assess the asset allocation of a portfolio. When you first use the asset allocation analyzer, you are asked to describe what kind of investor you are (you can modify this at any time). The analyzer then compares your asset allocation to AAII’s asset allocation models to see whether your current allocation is “conservative,” “moderate” or “aggressive.”
Once you’ve established an optimal asset allocation that meets your investment personality, it is advisable to rebalance back to your target allocations every so often, perhaps quarterly, twice a year or annually. And as you near retirement, or the time when you need the money for a key expenditure such as a child’s education or buying a new house, the assets required to fund that expenditure should be moved away from risky assets such as individual stocks and stock funds. The objective in these cases is preserving wealth, not amassing it.
For many investors, though, this task may seem daunting. Others, however, can handle the task and do it quite well. Some investors prefer to outsource the functions of portfolio assembly, rebalancing and adjusting to a more conservative asset allocation over time. This is where target-date funds come into play: They do all of this for you.
A target-date fund is a “fund of funds”—a fund made up of other funds. The underlying funds held in a target-date fund offer a diversified exposure to a mix of asset classes such as stocks (small-, mid- and large-caps), foreign stocks, bonds, foreign bonds and perhaps a portion of cash-like securities such as money market funds.
Target-date funds are designed to be held throughout a person’s lifetime. The asset allocation mix shifts dynamically and automatically, becoming “less risky” over a person’s working career and into retirement. These funds achieve this by rebalancing their portfolios over time to become less focused on asset growth (lowering their allocation to stocks) and more focused on wealth preservation (increasing their allocation to bonds) as the fund approaches and passes the target date. (The years in the fund’s name corresponds, approximately, to the investor’s retirement date.)
According to data from Investment Company Institute (ICI), there was $1.8 trillion invested in target-date funds as of June 30, 2021. A primary reason for their popularity is their relative ease of ownership—they offer a hands-off approach to portfolio diversification, with asset allocation and rebalancing that professional managers are making.
You may have a limited number of choices, but there are still some key factors involved in selecting a target-date fund. Here are some things to consider.
Low fees
More definitely isn’t better when it comes to how much you pay to own a mutual fund, and the same holds for target-date funds. For that reason, it is essential to pay attention to the overall cost of owning a target-date fund. Often, you pay the blended costs of the underlying funds held by the target-date fund and the additional management fees the adviser charges to implement their asset allocation “glidepath” (I discuss the target-date fund’s glidepath shortly). It’s worth noting that target-date funds that are closer to their target retirement date tend to be less expensive because their asset mix is starting to move away from the higher-priced equity portion and toward lower-cost fixed-income options.
All else equal, look for target-date funds with low fees.
Since I am in my mid-40s, I put my target retirement date around 2040.
Using the Funds+ mutual fund screener available to A+ Investor subscribers, there are 91 no-load 2040 target-date funds that are non-institutional funds, are open to new investors and have a minimum purchase amount no greater than $10,000.
Adding the additional requirement that the target-date fund rank in the bottom 20% of its category in terms of expense ratio lowers the number of funds to 19.
Since I am a fan of Vanguard funds, that led me to the Vanguard Target Retirement 2040 fund 
(VFORX).
According to data on the fund provided by the Fund Evaluator, it is a true no-load fund, charging no front load, deferred charge or redemption fee. The fund also does not charge a 12b-1 fee. Overall, the fund charges an annual expense ratio of 0.08%.
According to the Vanguard website, the fund offers a diversified portfolio with a single fund that adjusts its underlying asset mix over time. The fund provides broad diversification while incrementally decreasing exposure to stocks and increasing exposure to bonds as its target retirement date approaches. The fund continues to adjust the mix for approximately seven years after the target retirement date. The fund is for those planning to retire between 2038 and 2042.
An asset mix that suits your risk tolerance
Depending on the fund family, target-date funds with the same target retirement date may invest more aggressively than others, specifically with a higher allocation to stocks, including foreign stocks.
The Vanguard Target Retirement 2040 fund currently invests 78.5% in stocks, with a breakdown of 46.9% in domestic and 31.6% in foreign stocks.
Among the 19 target-date 2040 funds that meet my filters, the allocation to stocks ranges from 90.1% for the Fidelity Freedom Index 2040 Investor fund (FBIFX) to 76.5% for the Allspring Target 2040 R4 fund (WTFRX). The Legal & General Retirement Income 2040 fund (LRIWX) does not have a reported stock allocation.
Looking at foreign holdings, the allocation among these 19 target-date 2040 funds ranges from a low of 16.9% for the Mutual of America 2040 Retirement fund (MURLX) to 42.3% for the Fidelity Flex Freedom Blend 2040 fund (FCLSX).
This data reinforces the need to examine the underlying exposure to stocks and foreign stocks as well as fixed income, especially the allocation to high-yield bonds, to see if this allocation suits your risk tolerance.
The Fund Evaluator pages generated by A+ Investor provide statistics about a fund’s portfolio. For example, here is the snapshot of the big-picture asset allocation for the Vanguard Target Retirement 2040 fund. Here you see that the fund’s stock allocation is 78.5%, with 46.9% in domestic stocks and 31.6% in foreign stocks.
A “glidepath” that makes sense
I’ve mentioned the term “glidepath” a few times, so it’s worthwhile expanding on what exactly it means. A target-date fund’s glidepath refers to a formula that defines the fund’s asset allocation mix, based on the number of years to the target retirement date. The glidepath creates an asset allocation that typically becomes more conservative—lowers the allocation to stocks and increases the allocation to fixed-income assets—as the fund gets closer to the target retirement date. Generally speaking, the glidepath is the rate at which a target-date fund adjusts its allocations to stocks and fixed-income investments over time.
Some target-date funds invest more heavily in stocks throughout the fund’s life believing that a higher allocation to equity—and the higher returns it typically generates—is necessary to ensure that investors don’t outlive their savings. On the other hand, target-date funds that invest more heavily in fixed-income assets throughout the fund’s life operate with the belief that being more conservatively invested will preserve wealth and lower the risk of a significant market downturn. This, in theory, will reduce the likelihood of not having enough money for retirement.
You can learn more about a target-date fund’s glidepath from the fund family. For example, at the Vanguard website, I found data for the target allocation of the Vanguard Target Retirement 2040 fund at the retirement date and the final allocation that it reaches approximately seven years after the retirement date.
To get an idea of what the target allocation will be in 2040, we can look at the allocation for a “current” Vanguard allocation fund, the Target Retirement 2020 fund:
When investing in a target-date fund, a relevant question is: What happens once the fund reaches its retirement date?
Different target-date funds take different approaches when they reach their retirement date. For example, some funds convert their assets to a retirement-income fund at the target date, while others do so years after reaching the target date. Still, others maintain the assets in the original fund and keep the same name, even though the target date has passed.
For example, the Vanguard Target Retirement 2015 fund (VTXVX) is still in operation even though it hit its target date seven years ago.
Currently, Vanguard Target Retirement funds with target retirement dates that are more than seven years past their target retirement date have this allocation, as shown in the inset box:
The glidepath that target-date funds follow to their final allocation rests in two seemingly innocuous, but critical, words: “to” versus “through.”
A “to” glidepath means that the fund manager stops adjusting the fund’s allocation at the retirement date. In contrast, a “through” glidepath implies that the manager continues to adjust the allocation beyond the target retirement date.
According to Morningstar, one of the key differences between a target-date fund with a “to” glidepath versus one with a “through” glidepath is that, even if they have the same retirement date and both start out with similar allocations to equities, the average “to” path decreases the equity allocation more rapidly than the average “through” glidepath.
The average “through” fund hits the target date with a higher allocation to equities and can lower this exposure over the next 20 or 30 years before landing at its final allocation. This longer glidepath offers greater protection against longevity risk since equities tend to outperform other asset classes over long periods. In contrast, the quicker drop in exposure to equities for “to” glidepaths tends to lower the risk of exposure to a sharp downturn in stocks when the investor is close to retirement.
The Vanguard Target Retirement funds we’ve discussed are considered “through” funds, since they continue to adjust their allocation up to seven years after the retirement date, but they do so at a quicker pace than other “through” funds.
For many investors, target-date funds are a no-brain solution. But there are some caveats worth mentioning that mean they don’t work for everyone.
First, investors have no control once they select the target-date fund. They cannot adjust the investment or allocation decisions of the fund. In addition, by choosing a target-date fund, you are usually limited to a given fund family’s funds. Most target-date funds use their own underlying funds to build their portfolio. One drawback is that few fund families offer best-in-class funds across all asset classes.
Returning to the Vanguard Target Retirement 2040 fund example, the Vanguard site also provides the funds used to arrive at the target allocations throughout the fund’s glidepath:
Here we see that the 2040 target-date fund currently uses four Vanguard funds to achieve the current asset allocation: Total Stock Market Index Fund, Total International Stock Index Fund, Total Bond Market II Index Fund and Total International Bond Index Fund.
Over time, the exposure to stocks declines while bond allocation increases as the target date approaches. Eventually, the fund will also add the Vanguard Short-Term Inflation-Protected Securities Index Fund as it nears the target retirement date.
Also, target-date funds are intended to be used as a total-portfolio solution. If you own additional holdings, you must also consider them to make sure you achieve your overall asset allocation. This also means it is up to you to perform periodic rebalancing to ensure that your entire portfolio aligns with your target allocation.
However, the bottom line is that target-date funds are a comprehensive and easy-to-use solution for retirement savers. They are a one-step solution for setting up a diversified portfolio and maintaining a reasonable asset allocation for years, and even decades, to come.
