This is a guest post from Frank Curmudgeon, who writes about bad money advice at his aptly-named blog, Bad Money Advice.

You may have heard of target-date funds. In 2006 they were okayed as default investment options for 401k accounts, so if you said nothing about where you wanted your 401k money to go, you might even have found yourself the proud owner of one.

A target-date fund is a mutual fund that is made up of other mutual funds. It’s sort of an all-in-one solution that contains a variety of fund types in an attempt to create a diversified portfolio that could serve as all the investing a person needs. Each target fund has a year in the future associated with it, intended as an approximation of the investor’s planned retirement date. So a target fund dated 2015 would be more conservatively invested than one dated 2040.

Are they a good idea for you? Well, target-date funds are not terrible. They make reasonable default options, but you can probably do much better. To understand what might make them less than ideal, consider the following.

The trouble with target-date funds
Imagine that your local supermarket, in order to reduce the stress and confusion of shopping, started a new service: Target Shopping. Instead of having to push a cart through the aisles and make purchase decisions on your own, now all you need to do is hand your money over to an expert Target Shopping Specialist. This expert will select, based only on the ages of the members of your family, the ideal mix of groceries for you and have them put in the trunk of your car. As a consumer, would you think this is a good idea? Now suppose you were the store manager. Would this be a good business?

I don’t think anybody would want to have somebody else pick their groceries based on demographic information about their family. But I bet the store manager would think this idea was just totally awesome. Even if he didn’t charge anything for this “service” beyond the normal price of the groceries involved, being able to decide what the customers bought would be super convenient. He could make sure they bought the high profit items and stayed away from the loss-leaders. If there was too much of an item one week, the Target Shoppers could take it off the store’s hands. And, of course, they would never get anything that was on sale.

There are two problems here:

  • The person selecting the products is unlikely to get it right, even if perfectly honest, because they know so little about the customer.
  • They have lots of incentive not to be perfectly honest.

From the point of view of a consumer/investor, target-date funds have basically the same problems. You are asking a company to make a decision about the risk you are willing to take based on only one tiny bit of information about you: the year in which you hope to retire. Further, that company has a significant conflict of interest, because when they pick your investments they are also deciding how much profit they are going to make.

Even within a single company’s mutual fund offerings, the fees that funds charge — and the profits they make for the company — can vary a great deal. As a general rule, the more risky the fund the higher the fee, so stock funds have higher fees than bond funds, growth stock funds that invest in small companies have higher fees than value funds that invest in big stodgy ones, and so on. As a result, the more risk the target fund manager decides you should take, the more money they make. Are you comfortable with that?

And there is a conflict of interest even without considering fees. Like any business, mutual fund companies have some products that sell well and some that sell poorly. There will always be the temptation to load up the target fund with the stuff nobody else wants.

By way of illustration, let’s take a quick peek under the hood of one of the biggest target-date fund families, Fidelity. (The other two big players are T. Rowe Price and Vanguard. Together the three are 80% of the business.) I hope to retire around 2035, so we’ll start there. Fidelity’s Freedom 2035 Fund is about 80% in stocks and 20% in bonds. That’s a little more exciting than I would like. (But it turns out that both T. Rowe Price and Vanguard are even riskier, at around 90% stocks.)

There are a total of 25 funds in the Freedom 2035 portfolio. Fidelity’s largest (most popular) fund, the Contrafund, is not on the list. Nor is the Spartan 500 Index Fund, known for its tiny annual fee of only 0.07%. Overall, Fidelity charges 0.77% for the target fund. That’s actually not bad; the average for 2035 target funds is 1.30%.

How to create your own target-date fund
For people who don’t know much about investing, target-date funds have a lot of appeal. You hand your money over to an expert and then don’t have to worry about it until retirement. But you can do better. Here’s a simple method to create your own target-date fund that will take only an hour or two of your time.

  1. Find your adjusted target date. Start with when you actually expect to retire. Then, to counteract the natural tendency of fund companies to skew things to the risky, deduct 15 years from that number. If you are a risk-averse person, knock off another five years. If you are the courageous type, add five years. (And if you are not sure if you are more or less comfortable with risk than the average person, try taking this quiz.)
  2. Bootleg your allocation percentages. Go to the websites of two or three target fund vendors (e.g. Fidelity, T. Rowe Price, and/or Vanguard) and, using your adjusted target date, find out what percentages those companies’ target funds are using for stocks, bonds, and cash. (If you wanted to get fancy, you could go further and break it down to U.S. stocks, international stocks, government bonds, corporate bonds, etc., but I don’t think this is really necessary.) A nice thing about target funds is that they are required to publicly disclose how they are invested. Average the percentages you find to make your own set.
  3. Roll your own. Take the stock percentage of your investment savings and put it in a low-cost index fund, such as Fidelity’s Spartan 500. Put the bond portion in a low cost bond fund, such as Vanguard’s Total Bond Market Index Fund. Put cash in a money market fund. Your average fees should be less than 0.20%.
  4. Once a year, rebalance. As the prices of the funds change, the percentages of your portfolio that they represent will drift away from the targets you set. Once a year, sell a little bit of the one that is too big and buy some of the one that is too small to get them back where they should be percentage-wise.
  5. Once every five years, repeat steps 2 and 3. As you get closer to retirement, you may want to get more conservative in your investments. But you may not want to bother with this step at all if you are under forty, as the percentages probably won’t change much.

This is not a perfect system (nothing is) and I can think of several ways to make it much more complicated and a little more effective. But as it is, it will give better results than investing in a target fund, for a very small expenditure in effort.

One possible roadblock is if your investments are inside a 401k plan, which limits your fund choices. If your plan does not include appropriate bond and stock funds to use for your allocations, but does have target funds, you might consider investing in a target fund using your adjusted retirement date rather than your true one.

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