Target Retirement Funds and Automatic Rebalancing

by Kevin on June 19, 2008

I have a guest post that will go live at Consumerism Commentary at 10AM Central that talks about what I see as the benefits of target retirement funds. If you’re visiting from Consumerism Commentary, thanks for stopping by! Please consider subscribing to my RSS  feed and commenting. Your comments are more than welcome.

I thought I’d pair it up with further thoughts this morning about the beauty of automatic rebalancing with a target retirement fund.

We need a foundation of understanding first.

What is rebalancing your portfolio?

Essentially, rebalancing your portfolio is buying/selling certain portions of the portfolio so that the items you are invested in match your investment plan. That doesn’t sound simple, but it is. Let’s say you want to be invested in 90% stocks and 10% bonds. During the year each is going to go up and down, and you might end up one year later with 95% stocks, 5% bonds. Your asset balance is out of whack.

So you sell some of your stock holdings or add more to your bond holdings to get back to your 90% / 10% balance. Every time you do this you are rebalancing your portfolio.

Rebalancing is easy and you probably won’t do it

Many people get busy and forget to even look at their 401k statements or where there investments stand on a year to year basis. Adding in yet another thing you have to do, especially if it involves a little math, makes it more unlikely you will rebalance.

I’ve read elsewhere that many people are invested in ultra-conservative investments in their 401k. Why? Because they don’t know what they’re doing and the “guaranteed return” on a money market fund paying 2% sounds great. If you don’t understand the investments, you probably don’t have an investment plan (which I will talk on in the future). If you don’t have an investment plan, how are you supposed to know what to buy/sell more of to get your portfolio back in balance? It’s a simple concept, but requires a few steps. Result? Most people don’t do it every year.

The Beauty of Target Retirement Funds

One of the most amazing things about Target Retirement funds is they rebalance for you. Automatically. You don’t have to even think “man, what should I buy more of? What should I sell?” The funds automatically adjust for you.

Over time the funds get more conservative. That makes sense. If you are 42 years from retirement (Vanguard Target Retirement 2050) you need more stock holdings in your portfolio. Stocks provide more growth over time than bonds even though there is risk involved. But if you are retiring in two years (Vanguard Target Retirement 2010), you can’t afford an enormous loss in 2009 right before you start drawing income from your retirement account. So as time marches on the funds boost up the bond holding percentage to provide more stable income.

Let’s compare the 2050 fund and the 2010 fund over the last year to prove the point. Remember, the 2010 fund is invested more conservatively with a higher percentage of bonds. The 2050 fund has more exposure to stocks. The blue line is the 2010 fund, the red is 2050. You can click the image for full size.

Vanguard Target Retirement 2010 vs 2050 over the last year

What do we see? The last year has been a wild ride on the stock market. The fund with the higher allocation of bonds — 2010 — has not experienced as big of a gain or loss over the past year. It comes out to be about 1/2 of what the heavy-stock allocated fund experienced.

That’s to be expected. But just think if you are about to retire, and you are invested in the 2050 fund. You have lost 7-8% over the last year! That can really put a dent into a retirement portfolio. But thanks to the target retirement fund if you have the right date picked out (2010 versus 2050), the funds will automatically get more conservative for you. End result? Hopefully less retirement headache.

I highly recommend starting your Roth or Traditional IRA with a Target Retirement Fund. It is definitely a set it and forget it type investment, which makes things easier for you. I do recommend Vanguard, but I will put up a disclaimer: I am invested in the 2050 fund. That’s it. Vanguard doesn’t pay me to toot their horn. The low fees and exalted status in the investment world is all I need to talk about them.

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Taylor July 16, 2008 at 8:09 am

You talk about Vanguard, but what about Fidelity?? They appear to be just as good for my Roth Ira??

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