The One-Stop Portfolio

EDITOR'S NOTE: This article is from Kiplinger's Mutual Funds 2008 special issue. Order your copy today.

Target-date mutual funds are simply a great way to save for a long-term goal—especially retirement. The concept is simplicity itself: Choose the year you'll need the money, then pick the fund with the date closest to your target. So, for example, if you're 35 and plan to retire in 2038, you'd choose a fund with 2040 in its name.

These funds are a balanced meal of investments, complete with big-company stocks, small-company stocks, bonds and often less-traditional assets, such as emerging-markets stocks and real estate stocks. As the target date approaches, the fund becomes more conservative, lowering the percentage of assets in stocks in favor of more bonds and cash. This "glide path" is meant to dampen the fund's volatility, reducing the likelihood of big losses as you near the year you'll need to tap the fund.

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Money in target funds has grown like kudzu since their introduction around the beginning of this decade—from $12.3 billion in 2001 to $168 billion at last word. The number of fund families offering target-date funds has jumped from a handful five years ago to 35 today. That number is bound to rise, thanks to a ruling by Uncle Sam. The U.S. Department of Labor recently issued guidelines that place target funds on the short list of approved default investments in employer-sponsored retirement plans.

Maybe it's because so many companies want a stake in the target-fund business that it seems everyone's a critic these days. Naysayers are accusing target-date funds of being inflexible, too risky or too hidebound.

But don't let such debate shake your faith. Much of the noise surrounding target-date funds is the industry overthinking a sweet and simple concept. For our favorite target-date funds, see How to Pick a Target Fund.

Getting aggressive

In an effort to improve performance and break from the pack, many target-date funds have boosted their holdings in riskier investments. While more-aggressive target-date funds topped out at 80% stock allocations three years ago, some now have as much as 94% in stocks, says Hewitt Associates, a human-resources consulting firm.

The growing slice of foreign stocks, in particular, underscores the push toward performance and the divergence among target-date funds. In recent years, one of the best ways to crank up a portfolio's performance has been to look overseas. The MSCI EAFE index, a widely used barometer of performance in developed foreign markets, returned an annualized 22% over the past five years to December 1, 2007. Standard & Poor's 500-stock index gained 11% annualized over that period.

Vanguard's target-date funds have up to 18% of their stock allocations in overseas companies. Compare that with the 22% maximum in T. Rowe Price target funds and the 35%-plus maximum in AllianceBernstein and John Hancock target funds.

Is putting so much in foreign stocks the right move? Time will tell. But you don't want your target-date fund to chase fads. Says John Ameriks, an analyst in the investment-counseling and research group at Vanguard: "I think a lot of the foreign-stock popularity is more about recent performance than good investing."

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Soft landing

Two key premises of target-date funds are that they're simple and that they stick closely to a designated stock-and-bond mix over time. But even those principles are being challenged.

Compass Institute, a think tank on retirement-plan strategies, warns that many target-date-fund investors will end up with insufficient nest eggs because glide paths are too rigid. Compass recommends a strategy of shifting from stocks to bonds and cash during falling stock markets, and doing the reverse during stock-market run-ups. Compass calls its strategy "risk management asset allocation." But to us, it sure looks a lot like market timing, a practice that target-date investors should avoid.

Some companies want to take a multiple-choice approach to target funds. For example, Old Mutual Asset Management and Wilshire Funds Management are developing different funds for different target dates with varying stock-and-bond mixes. The idea is that investors who feel they need to earn more money or want more risk will go with, say, the Target Date 2040 Aggressive fund, while others who have already achieved their goals or want to avoid risk will invest in the Target Date 2040 Conservative fund.

But there are a couple of problems with such an approach. First, providing more choices could confuse investors and may dissuade them from investing in any target-date plan. Second, switching to a riskier portfolio is a questionable way to make up for lost time. The prudent way is to save more or to delay retirement. "No investment mix in the world is going to save someone if she or he hasn't put enough money toward retirement," says Don Stone, president of Plan Sponsor Advisors, a retirement-plan consulting firm.

All the criticisms aside, we like target-date funds because they do for you what you often can't do for yourself. John Hancock recently released a study showing that over the past ten years, 84% of those who put together their own portfolio of funds inside a Hancock-run 401(k) would have earned more in a single Hancock target-date fund. Those who invested in target-date funds (and similarly diversified portfolios before target funds were invented) earned an average of two percentage points per year more than those who invested on their own.

The Hancock study found that investors who didn't hold target-date funds made classic mistakes that cost them money over the long run. They put most of their money into funds that were popular at the time they enrolled in a retirement plan and made few changes afterward. And they tended to have either very risky or very conservative portfolios. A diversified portfolio is "the only free lunch" in investing, says Bob Boyda, senior vice-president of investment-management services at Hancock. "It's proven to earn you more and let you sleep better at night."

How does a well-balanced portfolio accomplish so much? Different types of investments don't move in lock step. So while a big-company stock fund may be down 5% one year, a small-company stock fund may be up 15% the same year. Assuming equal amounts invested in both, together they make 10%. Now mix in a foreign-stock fund, a real estate fund, maybe a bond fund… you get the idea. The return of a portfolio becomes more stable.

And with a solid portfolio you can safely add a pinch of some high-risk but high-reward investments -- say, emerging-markets stocks. Over time, they should boost your return a bit, and if they blow up completely, it's no huge loss to the portfolio.

Target funds may not be the be-all and end-all of retirement investing, but as Vanguard's Ameriks says: "If you never make another investing decision in your life, it's not a bad one. And if you want to do better than this, it's going to take some work."