Without question, the single biggest key to successful investing is diversification. Keep your eggs out of the proverbial single basket, and you’ll do well in good times—and you won’t get hurt in bad ones. So, what’s the best way to diversify? Even most mutual fund investors pick anywhere from five to 10 funds, each in a different sector of the market. But there’s an easier way.
Bill Dyszel, a communications executive in Manhattan, plunked his 401(k) savings into a single mutual fund. Hannah and Mike Resig of Falls Church, Virginia, did the same. Dyszel, 57, chose the Fidelity Freedom 2025 Fund, and the Resigs, both 25, opted for the American Funds Target Date Retirement 2050 Fund—both known as a “target-date” or “life-cycle” fund. (The years —2025, 2050—stand for retirement dates.)
According to Morningstar, contributions to this type of funds have soared in recent years to $420 billion—double what it was five years ago.
The basic strategy behind a target-date fund is to provide a well-diversified portfolio that starts off aggressively and then, as time rolls on, shifts to a more conservative strategy. Thus younger investors, like the Resigs, wind up with mostly stocks and few bonds. Older investors, like Dyszel, who are closer to retirement, carry more bonds and fewer stocks. The ratio of stocks to bonds shifts automatically each year. Estimate your retirement date and a formula does the rest. One reason for these funds’ popularity is that in 2007 the Department of Labor passed a regulation that led many employers to use life-cycle funds as the defaults in 401(k) plans. If workers fail to make another choice, contributions to 401(k) go directly into a life-cycle fund. But the rise in assets is attributable to more than this ruling.
Dyszel chose the life-cycle option for its simplicity. “I didn’t want to spend time figuring out what to invest in and when to invest it,” says Dyszel. For the Resigs, just starting to build wealth, the life-cycle option seemed too sensible to resist. “These funds take into account that when you’re younger, you can afford to take more risk,” says Hannah.
Jerome Clark, portfolio manager of T. Rowe Price’s line-up of retirement funds, says that 90 percent of his savings is in his employer’s life-cycle option. “These funds are a great core holding for almost everyone,” says Clark. “Many younger people invest too conservatively, while many older investors invest too aggressively. With life-cycle funds, the allocations for investors vastly improve.”
Interested in life-cycle funds? “These funds are the easiest investments you can make, but you still need to do research to make the best decision,” says Clark. Some key considerations:
1. Study the strategy.
While all life-cycle funds start off aggressively and then grow more conservative, the rate of progression varies widely. The Fidelity Freedom 2025 Fund is currently 60 percent in stocks, while American Funds Target Date Retirement 2025 Fund and T. Rowe Price Retirement 2025 Fund are both 75 percent in stocks. If you like a fund company but find their mix too aggressive, simply choose a target date closer to home—for example go with the 2015 fund, rather than the 2025 fund.
2. Look carefully at fees.
Life-cycle funds charge fees that can vary considerably. According to Morningstar, the average life-cycle fund charges 1.08 percent a year in management fees. Other options in your 401(k) plan may be much less expensive. If that’s the case, “ask yourself how much the simplicity is worth to you,” says Everette Orr, a fee-only financial planner in Virginia.
3. Consider the mix.
Look at the fund’s diversification (does the stock portfolio have U.S. and international exposure?), the strength of management (how long has it been around?), and historical performance.