The Target Date Fund

Matthew started a Roth IRA and used a target date fund. Would Dave move out of the target date fund into a growth stock mutual fund?

QUESTION: Matthew in Financial Peace Plaza started a Roth IRA when he was younger and used a target date fund. He wants to know the difference between a target date fund and a growth stock mutual fund. Would Dave move out of the target date fund into a growth stock mutual fund?

ANSWER: I would roll to a series of growth-stock mutual funds. I put mine across four types of funds: a fourth in growth, a fourth in aggressive growth, a fourth in international and a fourth in growth and income. That group gives you a good diversification across risk as well as having a little splash overseas.

You can watch those year in and year out and see how they are doing compared to that particular category in the market. For instance, if my international fund made 5% for the year and I don’t think that’s good, but I see that other things in the international fund made 4%, then it actually would be good. If the others in that same category, however, have made 15%, then I might start to think that I’ve got a bad one. That’s how you look at your funds year to year.

What a target date fund does is it preserves this theory that the financial community believes by and large is the best thing to do. I don’t believe this theory, which is called asset allocation. It means when you are young, you invest aggressively. The older you get, the more you move to less aggressive funds. By the time you are 65, you are pretty much in money markets and bonds. The idea being that, hypothetically, that’s not as risky as the type of investments I’m talking about.

I don’t believe in that, and here’s why: It doesn’t work. That kind of investing is what the target date does. A lot of people have target date funds in their 401(k) plans as their default. They don’t pick anything, so their company throws them in a target date.

You are a young guy, so at your age, the money is probably in the aggressive category. What I just outlined is an aggressive category according to that product. It’s not that aggressive, but when compared to bonds and money markets, it’s risky.

I don’t believe in it because if you live to age 65 and are in decent health, there is a high statistical likelihood that you will make it to 95. The average death age of a male is 76 years old, but that includes infant mortality and teenage death. When you make it in good health to 65, your life expectancy right now is about another 30 years.

If you move your money to money markets and bonds at age 65, inflation is going to kick your tail up around your neck. You will have no purchasing power with that money. Your money will grow slower than it will devalue. That’s the problem with the asset allocation methodology.

It’s a broken theory, but the problem is that the financial community, by and large, is made of a bunch of lemmings. They all follow each other right off a cliff and do what the other one does. It’s not the best way of doing things. That’s why I don’t like the target date; it moves you automatically as you move through life to less and less risk. But that means less and less return.

I’m 53, and I still like making big returns. I love that my mutual fund portfolio made in the 20% range last year. I don’t want to be in some stinking investment making 5% because I am approaching the last 10 years of their model up to age 65. I have another 30 or 40 years to invest, hypothetically.

At your age, it’s not an emergency. It’s probably invested fairly well. I just want you to understand the concept and the theory behind it. You could do it sometime in the next year and be fine. But as you get older, the thing is going to do a poor job for you. For the people in the thrift savings plan, they have an L fund right now, and that’s the same kind of stuff.