Young investors are being hammered with information about investing early. Everybody in their 20s has heard of the benefits of compounding in some form, and that’s a very good thing. The benefits of compounding are real and there’s no better time to take advantage of them than when you’re young and have the longest time horizon to invest. However, many of these young people know that they should be investing, but they don’t necessarily know how to invest.
Luckily, there’s a popular trend in the investing community that can help with this. Target-date retirement funds are built on the premise that an investor generally should hold riskier investments when young and over time shift toward safer investments. To do this, a younger person would hold a greater percentage of stock versus bonds when young, and over time sell some of those stocks and purchase bonds. Target-date retirement funds will automatically do this for you as the specific target date draws nearer. For example, a 2020 target-date retirement fund will have a great portion of its portfolio in bonds than a 2040 target-date retirement fund.
But simply re-allocating between stocks and bonds is not all that these funds do. These funds provide diversification within them by investing in a diverse portfolio of index or mutual funds, holding domestic and international stocks, with the potential for real estate holdings (REITs) as well. Because of their simple, hands-off approach to investing, it’s easy to see why target-date retirement funds have become popular amongst investment planners. They’re a quick and easy way to get someone’s retirement investing on track.
However, investing is never as simple as a general rule of thumb might suggest. While target-date retirement funds are great for most people, you can’t simply rely on that designation to determine whether it’s the right investment for you. Frankly, there are too many target-date retirement funds that invest in actively managed mutual funds and don’t do a good job of controlling costs. For example, let’s say that I start investing at age 25 in a 2050 target-date retirement fund within my Roth IRA and I contribute $5k per year until I’m 65. If I invest in a target-date fund from Vanguard, I’d have low fees and let’s imagine I end up with an average return of 9% after fees. At age 65 I’d have approximately $1,841,000 in my Roth IRA. Now, if I am investing in a fund that takes just 1% more each year, then I am earning a net 8% on my investments. Over that same period, with the same contributions, I’d only end up approximately $1,399,000. That’s more than a $400,000 difference due to the 1% higher fee taken by a different fund.
If you’re looking to invest your money, but don’t want to spend the time or effort to determine your own optimal portfolio, then I absolutely recommend looking into target-date retirement funds. SmartMoney has published a good guide on the best target-date funds here. In it’s article, SmartMoney notes that Vanguard’s funds are 5 times cheaper than average, and they were one of just two funds that was using mostly index funds to construct its target-date funds. You can also check out MorningStar’s rankings of target-date retirement funds, where it lists Vanguard as the top provider. If I were going to point a friend in a single direction to make their retirement planning simple, I’d tell them to check out their appropriate target-date retirement fund from Vanguard.