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Lessons from Target-Date Funds

Target-date funds, those one-decision investments that adjust the mix of assets to become more conservative as your retirement or other goal approaches, can teach us all about how to deal with challenging markets, says Anne Kates Smith, Kiplinger’s Personal Finance, www.Kiplinger.com.

“Since target-date funds debuted in 1994, their assets have grown to $1.2 trillion, up sixfold from a decade ago. The funds are often designated as the default option in retirement plans. Because of their diversification mandate, target-date funds will never be top performers. Something in the portfolio will almost always be ho-hum (or worse) when other parts are rising. Over the past five years – a strong bull market for stocks – even the funds with the highest allocation of stocks relative to bonds returned an annualized 10 percent, compared with a 13.8 percent return for Standard & Poor's 500-stock index.

Nor will target-date funds save you from getting mauled in a bear market. The funds faced sharp criticism after the bear market of 2007-09 put a serious crimp in the plans of savers near retirement.

What target-date funds do better than most other types of funds, a recent Morningstar study shows, is save us from ourselves.

Morningstar looked at what it calls a fund's investor return and its total return. Total return reflects what you'd make if you invested a lump sum at the beginning of a period and held it to the end. Investor return accounts for when you buy or sell fund shares – and given human nature, that's typically at inopportune times. There's often a performance gap between the return of the average investor and a fund's total return over any given period. When investor returns lag total returns, it means that investors suffered more of a fund's losses or enjoyed less of its gains.

With target-date funds, investors have done a good job of capturing upswings and not piling in just in time for downswings. From March 1994 through January 2018, investor returns in target-date funds lagged total returns by a modest 0.38 percentage point per year, Morningstar found. For the five-year period ending in January 2018, investor returns in the funds beat total returns by an average 0.21 percentage point a year.

What's the secret to success for target-date investors? The funds make it easy to stick with a savings plan. Investing at regular intervals can beat a buy-and-hold strategy because you automatically buy at low prices during down markets. Morningstar found that when outflows were heavy in target-date funds, they tended to be confined to the funds approaching their target dates – in other words, redemptions had more to do with, say, investors reaching retirement or their kids matriculating at college than with trying to time the market.

Editor’s Note: Anne Kates Smith is executive editor of Kiplinger's Personal Finance magazine, www.Kiplinger.com.

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