What We Can Learn from Target-Date Funds

You may or may not be a fan of target-date funds. But those one-decision investments, which adjust the mix of assets to become more conservative as the year of your retirement (or some other goal) approaches, can teach us all a thing or two about how to deal with challenging markets. Since target-date funds debuted in 1994, their assets have grown to $1.2 trillion, up sixfold from a decade ago. The funds are often designated as the default option in retirement plans.

Because of their diversification mandate, target-date funds will never be top performers. Something in the portfolio will almost always be ho-hum (or worse) when other parts are rising. Over the past five years—a strong bull market for stocks—even the funds with the highest allocation of stocks relative to bonds in the category (those with a target date of 2060 or beyond) returned an annualized 10%, compared with a 13.8% return for Standard & Poor's 500-stock index.

Nor will target-date funds save you from getting mauled in a bear market. The funds faced sharp criticism after the bear market of 2007-09 put a serious crimp in the plans of savers on the cusp of retirement. The 2010 target funds of American Funds, T. Rowe Price and Fidelity lost 36%, 35% and 33%, respectively, during the slump.

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Steady investing. What target-date funds do better than most other types of funds, a recent Morningstar study shows, is save us from ourselves.

To see how, you need to know the difference between what Morningstar calls a fund's investor return and its total return. Total return reflects what you'd make if you invested a lump sum at the beginning of a period and held it to the end. Investor return accounts for when you buy or sell fund shares—and given human nature, that's typically at inopportune times. There's often a performance gap between the return of the average investor, struggling with a tendency to buy high and sell low, and a fund's total return over any given period. When investor returns lag total returns, it means that investors suffered more of a fund's losses or enjoyed less of its gains.

With target-date funds, investors have done a good job of capturing upswings and not piling in just in time for downswings. From March 1994 through January 2018, investor returns in target-date funds lagged total returns by a modest 0.38 percentage point per year, Morningstar found. For the five-year period ending in January 2018, investor returns in the funds beat total returns by an average 0.21 percentage point a year.

What's the secret to success for target-date investors? The funds make it easy to stick with a savings plan. Win that battle, and you've won the war. "Target-date fund investors appear to have been the picture of consistency," says study author Jeffrey Ptak. Collectively, investors have put more money into target-date funds than they've taken out in all but seven of the 287 months in the study.

Investing at regular intervals can beat a buy-and-hold strategy because you automatically buy at low prices during down markets. Morningstar found that when outflows were heavy in target-date funds, they tended to be confined to the funds approaching their target dates—in other words, redemptions had more to do with, say, investors reaching retirement or their kids matriculating at college than with trying to time the market.

That's a lesson all investors can take to heart, whether you own a target-date fund or not. Contribute consistently to a diversified portfolio that's in keeping with your risk tolerance. (That last part is important, as recent market gyrations prove. If you can't sleep at night when the market is seesawing, or if you need the money within a few years, your plan might need tweaking.) Keep your portfolio on track by rebalancing regularly. Otherwise, sell for reasons that have more to do with your life stage rather than with your (or some guru's) opinion of where the market is headed next.

That's an easy strategy to embrace in a rising market that's mostly calm. But as 2018 has shown, "those trends could easily reverse themselves," says Ptak. That's when the steadiest of target-date investors will be put to the test.