Using Target-Date Funds to Dial Your Risk Up or Down

Target-date funds are available in just about every 401(k) these days and most other investment accounts as well. And they can be incredibly useful for two main reasons.

First, target-date funds combine multiple mutual funds into one, making it easy to get a fully diversified portfolio without having to choose and manage multiple different mutual funds yourself.

Second, target date funds help you manage your asset allocation, which is simply the way you split your money between higher-risk, higher-return investments like stocks and lower-risk, lower-return investments like bonds. They do this in two ways:

  1. They set your initial asset allocation. This decision is usually based on an expected retirement age of 65. The further away that is, the more aggressive the corresponding target-date fund will be.
  2. They adjust your asset allocation over time, slowly shifting into lower-risk investments as you near and enter retirement.

This takes a lot of the burden of managing your portfolio off your plate, which can be a huge help no matter your level of investment expertise.

The catch is that target date funds assume that everyone who is the same age should take on the same level of investment risk. That is, everyone who will turn 65 in the year 2040 will be defaulted into a Target Date 2040 fund, meaning they will all have the same asset allocation and therefore the same level of investment risk.

But asset allocation isn’t one-size-fits-all. You may have good reasons to want more or less investment risk based on your personal goals and preferences, meaning that your default target date fund may not be the right choice.

The good news is that in most cases you can still use target date funds, and take advantage of their benefits, while dialing your investment risk up and down. Here’s how to do it.

Why You Might Want to Dial Your Investment Risk Up or Down

Asset allocation is an inexact science.

In general, it makes sense to have more of your money in stocks when you’re younger given that you have more time to ride the ups and downs, and to slowly get more conservative as you age and your investment timeline shrinks. And this is broadly what target date funds do.

But age isn’t the only important variable for choosing your asset allocation, and it’s simply not possible for target date funds to account for all of the personal reasons why you may want more or less risk than someone else.

Here are some of the main reasons why you might want to dial your investment risk up or down.

Reasons to Dial Your Investment Risk Down

1. Investing makes you nervous.

While the stock market has always gone up over long periods of time, the ride can be pretty bumpy along the way. There are occasionally big losses that you have to endure, and while the smart move is to simply ride those periods out, it’s not always easy to do.

If investing makes you nervous, it’s probably better to dial back your risk instead of exposing yourself to bigger losses than you’re willing to take.

2. Your timeline is shorter than expected.

You may be planning to retire earlier than age 65, in which case you might want a little more certainty than someone with more time to make adjustments.

Or you may be investing for a different goal, like saving for college or buying a house. There’s no rule that says target date funds have to be used for retirement, and a nearer-term goal may call for a more conservative portfolio.

Reasons to Dial Your Investment Risk Up

1. Your timeline is flexible.

If you’re willing to be flexible about when you reach your investment goal, and if you like the idea of taking on more risk in return for a higher upside, you may want to invest more aggressively than the default target-date fund.

2. You don’t need the money.

If you’re already on track for your investment goal through other means, and this particular investment is more like a bonus, you can afford to get more aggressive because there isn’t any real risk.

How to Use Target-Date Funds to Dial Your Risk Up or Down

The good news is that wanting more or less investment risk doesn’t prevent you from using a target-date fund. In most cases it’s simply a matter of doing a little more work to find the right one.

The first step is setting your desired asset allocation. By doing this first, you’re letting your personal goals and preferences lead you to the right target-date fund, rather than the other way around.

Vanguard has a questionnaire that can help you determine the right asset allocation, and you can also use this guide to fine-tune your decision.

With that in hand, the next step is figuring out which target date fund most closely matches that asset allocation. This information isn’t always front and center, so you may have to do a little digging.

I like to use the site Morningstar for this kind of research. Here’s how to do it:

  1. Use the Quote field at the top of the page to search for the target-date fund in question.
  2. Navigate to the Portfolio section.
  3. The Asset Allocation section shows you how the target date fund is allocated across different types of investments. You can add the Net % for Cash to Net % for Bonds to get the total percentage that counts as “bonds” in the overall asset allocation.
  4. If that bond percentage is close to what you landed on for your desired asset allocation, you can feel good about using this target date fund for whichever goal you’re working towards.

Target-Date Funds for Any Purpose

Target-date funds offer a number of benefits. They give you a fully diversified portfolio with a single fund. They keep that portfolio in balance and automatically dial back the risk as you age. And in some cases they do all of that with minimal fees.

But target-date funds don’t know everything about your personal goals or your personal risk preferences. The default target-date fund, based on an expected retirement age of 65, may be more or less aggressive than you’d like or need.

The good news is that you’re not locked into that default choice. And with a little bit of extra research, you can usually find a target date fund that meets your needs and allows you to take advantage of the benefits these funds offer.

Matt Becker, CFP® is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families. His free book, The New Family Financial Road Map, guides parents through the all most important financial decisions that come with starting a family.

Related Articles: 

The post Using Target-Date Funds to Dial Your Risk Up or Down appeared first on The Simple Dollar.



Contributer : The Simple Dollar http://ift.tt/2jKuuG5
Using Target-Date Funds to Dial Your Risk Up or Down Using Target-Date Funds to Dial Your Risk Up or Down Reviewed by mimisabreena on Monday, December 04, 2017 Rating: 5

No comments:

Sponsor

Powered by Blogger.