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Investment Basics

Asset allocation

Studies indicate that more than 90 percent of variability of returns in a portfolio is the result of asset allocation — the process of distributing your investments across various asset classes in an attempt to moderate the inevitable ups and downs of your portfolio. Asset allocation is also referred to as diversification and simply means "Don't put all of your eggs in one basket."

Not all areas of the stock market go up or down in lock step. For instance, small company stocks may soar in the same year large company stocks struggle. Bonds and fixed investments may do well for a period while stocks struggle. To offset divergent performance, experts recommend a portfolio spread among a variety of asset classes. Things to consider before allocating your investments: risk tolerance (how well do you stomach market fluctuations?) and investment time horizon (how long until you need the money?).

A popular school of thought is that the longer your investment horizon the more weighted your portfolio should be toward stocks. Conversely, the closer you are to retirement the more your portfolio should be weighted toward fixed investments. It is Wise to reallocate your portfolio annually to meet your changing goals.

Model Portfolio

This chart is presented for illustrative purposes only and does not reflect actual performance, or predict future results, of any investment account.

The chart featured above (split 60% stocks and 40% fixed investments) is an example of a portfolio that has historically returned better than 8% (before fees and trading costs). Keep in mind that past performance is no guarantee of future returns. This portfolio may not be suitable for all investors.

It can often be difficult to allocate investments on your own, especially if you are just starting out and are contributing relatively small amounts. Many mutual fund companies now offer individual investments that are pre-allocated. These funds are known by a variety of names including: lifestyle funds, life-cycle funds, life-strategy funds, and target-date funds. These funds generally come in two styles. The first style remains set in its allocation. For example a fund in this category may be split 60% stocks and 40% fixed income investments. Other funds may be split 80% stocks and 20% fixed income investments. Instead of buying a myriad of funds to achieve diversification, you simply buy one of these funds.

The second type of pre-allocated fund is based on your age and your target retirement date. Typically known as target-date funds or target-date retirement funds, these funds are named after a specified retirement date like 2030 or 2035, or 2040. Investors simply choose their estimated target date for retirement say 2020 and contribute regularly to that one fund. The beauty of this type of fund is that they are initially weighted toward stocks but gradually shift to be more weighted toward safer fixed investments as the target date approaches. Operators of the fund make all allocation adjustments. Investors simply make regular contributions to this one fund. Many no-load target-date funds charging less than 1 percent in fees are available. For beginning investors there may be truly no better way to invest. Even for veteran investors these funds have a lot of appeal.

Index investing

An index is a collection of like minded assets. One of the most well known indices is the S&P 500 which is made up of the 500 largest publicly traded American companies. The S&P 500 is often referred to as the “market” since the overall performance of this index gives investors an indication of the health and direction of the United States market and economy. This is a terrific visualization of the companies that make up the S&P 500.

Instead of trying to beat the market (which is very difficult to do over time), one popular investing strategy is to simply buy an S&P 500 mutual fund. This is often known as index investing. Warren Buffett, considered to be one of the greatest investors, has said: "consistently buy an S&P 500 low-cost index fund... I think it's the thing that makes the most sense practically all of the time."

Other popular indices are the Dow Jones Industrial Average or Dow 30 which is made up of 30 large publicly traded American companies, and the Russell 2000 which is made up of small publicly traded American companies.

Target date funds

When it comes to participating in a 403(b) and/or 457(b) there are essentially two ways to go: do it yourself or use an advisor. The sheer complexity of investing can send even the savviest saver running for advice. The mutual fund industry believes it has the cure for the aspiring do-it-yourselfer looking for simple, low-cost option for saving for retirement.

Known by a variety of names — age-based, life-cycle, target-date retirement — former Marine and T. Rowe Price portfolio manager Jerome A. Clark, CFA, may have the best phrase to describe the increasingly popular breed of mutual fund which greatly simplifies saving for retirement. He calls it "fire and forget." It's a military expression that describes a weapon that automatically does what it is supposed to do allowing a soldier to return to safety. This is exactly how target-date retirement funds work. Investors simply choose an estimated retirement date in the future — say 2035 — and select the target-date retirement fund that corresponds most closely to this date. Fund operators take it from there as they guide the fund like a missile to its ultimate destination: retirement.

Asset Allocation Made Simple

Aimed squarely at retirement savers, these funds make the most critical and difficult part of retirement saving — asset allocation — simple. Studies indicate that more than 90 percent of variability of returns in a portfolio is the result of asset allocation — the process of distributing investments across various asset classes (stocks, bonds, cash) in an attempt to moderate the inevitable ups and downs of investing. Studies also indicate that investors are loath to alter initial allocation, meaning that most investors retire with the exact same allocation as the day they began. To prevent such a scenario which courts disaster, target-date funds automatically adjust asset allocation over time. The farther an investor is from retirement, the more weighted the fund is toward equities (stocks). The fund automatically becomes more conservative as the target retirement date approaches. For example, in 2019 the T. Rowe Price Retirement 2035 (TRRCX) fund was weighted 80% stocks and 20% fixed income investments, while the T. Rowe Price Retirement 2025 fund (TRRGX) was weighted 65% stocks and 35% fixed income investments.

Taking the Emotion Out of Investing

Fund manager Ren Cheng has overseen Fidelity's target-date Freedom Funds since 1996, and says the beauty of the target-date approach is that it takes the most volatile aspect of investing — emotion — out of the equation. "The average investment decision is based on emotion, not reality," Cheng said. To underscore the negative impact of emotion he points to the annual Dalbar Quantitative Analysis of Investor Behavior (QAIB) report which consistently shows that the average investor performs poorly. When the market declines, the average investor often sells. All too often the average investor buys high and sells low.

Early Pioneers

Wells Fargo Bank and Fidelity were early pioneers of the target-date approach. In fact, Chen has been involved since 1994 when Fidelity first began working on the concept. Today the Freedom Funds lineup boasts choices to the year 2050.

Allocation Varies Among Vendors

While all target-date funds operate in a similar fashion, allocation ratios vary. T. Rowe Price takes the most aggressive approach to allocation. "We are different from everyone else," Clark said. "We are not focused on retirement but the 30 year distribution period that follows retirement."

The following information is from year 2021:

  • Fidelity Freedom 2035 fund: stocks 83% – fixed income 17%
  • TIAA-CREF Lifecycle 2035 Retirement fund: stocks 76% – fixed income 24%
  • T. Rowe Price Retirement 2035 fund: stocks 84% – fixed income 16%
  • Vanguard Target Retirement 2035 fund: stocks 75% – fixed income 25%

For complete information on asset allocation consult each company's website

What Happens When the Target Date is Reached?

There is some variance among vendors, but generally the fund remains open for about five years as it gradually reduces stock exposure until its allocation mirrors that of a static (fixed) retirement fund (typically a 20% stock/80% fixed investment mix). At that point the fund is rolled into a static retirement fund operated by each vendor. T. Rowe Price takes a more aggressive approach that moves investors from a 55% stock/45% fixed investment mix at target date, down to a 20% stock/80% fixed investment mix over a 30 year period. If desired an investor can choose to be transferred to a static retirement fund (40% stock/60% fixed investment mix) at any time. T. Rowe Price cites the example of a 65-year-old retiree and an 85-year-old retiree. Manager Clark believes these investors have different time horizons and should have the choice of different retirement allocation options.

Fees Less Than Average Mutual Fund Cost

Target-date retirement funds offered by T. Rowe Price, Vanguard, TIAA-CREF (known as a lifecycle fund) and Fidelity (known as freedom fund) are all no-load and charge fees that are significantly less than the average mutual fund charge of 1.4 percent (Morningstar).

The following information is from year 2019:

  • Fidelity Freedom 2035 fund charges 0.73 percent. 
  • TIAA-CREF Lifecycle 2035 Retirement fund charges 0.68 percent.
  • T. Rowe Price Retirement 2035 fund charges 0.70 percent.
  • Vanguard Target Retirement 2035 fund charges 0.14 percent.

It is important to note that target date products are often funds made up of other mutual funds. T. Rowe Price, TIAA-CREF and Fidelity mostly employ actively managed products, while Vanguard relies mostly on index funds. For complete information on fund composition and fees consult each company's website.

Appealing Product for Plan Sponsors

Plan sponsors often lack money to provide retirement plan communication and financial education to employees. With target-date funds, plan sponsors can rest assured that they are providing a simple, cost-effective way for most employees to save for retirement that ensures the most crucial aspect of saving for retirement: proper allocation. A growing number of employers are using target-date funds as the default contribution and automatically enrolling new hires in age-suitable funds. "It makes perfect sense," said Fidelity vice-president market manager Tim Rouse. "The employer knows they are OK as far as proper asset allocation goes."

Appealing Product for Participants

"They appreciate the logic of it," said T. Rowe Price's Clark. "It makes sense." Vanguard's John Woerth echoes this sentiment: "These funds are designed for investors seeking a simple solution to their retirement needs whether they are in the accumulation, transition or withdrawal phase."

Designed to be Sole Investment in Portfolio

Because target-date funds promise diversification in a single fund they should be the sole investment in a portfolio. Mixing target-date funds with other funds can throw an investor's portfolio out of proper diversification. For example, if a person with a 2015 target-date mutual fund also owns stock funds, they may be overweighted in stock holdings, especially for an investor less than a decade from retirement. This isn't to say investors should never combine target-date funds with other funds, but if they do they must factor all of their holdings to determine if they are properly allocated for their investment situation.

No Single Approach is Suitable for All Investors

While no single approach is suitable to all investors, beginners and experts alike may appreciate the pure simplicity of the target-date approach which is important when so much about investing can be confusing: stocks, bonds, cash, value, growth, risk, allocation, small-cap, large-cap, sector fund, sub account, front-end load, back-end load, surrender charge, M & E, 12b-1, etc., etc., etc.

Note: This story was written in 2004 but has been updated with current allocation and fee information.

Market over time

The S&P 500 Index originally began in 1926 as the "Composite Index" comprised of only 90 stocks. According to historical records, the average annual return since its inception in 1926 through 2018 is approximately 10%.

Year by Year Return

S&P 500 Historical Chart