Seven reasons to put 100% of your portfolio in a target date index fund

Originally published at: https://www.personalfinanceclub.com/seven-reasons-to-put-100-of-your-portfolio-in-a-target-date-index-fund/

I love target date index funds. I believe they’re your best bet to maximize long term wealth and almost every individual investor should put 100% of his or her equity portfolio in a single target date index fund. Seriously.

What are target date index funds?

  • They’re named after a target retirement year: A couple examples are Vanguard’s Target Retirement 2050 Fund and Fidelity’s Freedom® Index 2055 Fund.
  • They’re index funds: That means there’s no smart guy getting paid a lot of your money to pick and choose stocks for you. Instead, they hold the entire “index” of available stocks. Index funds have much lower fees and studies show over and over they’re very likely to beat actively managed funds over time. Owning all the stocks guarantees you your fair share of market growth.
  • They’re “funds of funds”: Each is a single fund that holds inside of it several index funds. They’re usually composed of:
    • A total US stock market index fund
    • A total international stock market index fund
    • A bond index fund (may be split between US and international)
  • They reallocate over time: As time goes on they move from a heavy stock allocation to maximize growth while you’re young, to a heavy bond allocation to provide income and capital preservation in retirement.

Seven reasons to put 100% of your portfolio in a target date index fund

  1. Diversification: They contain thousands of US and international stocks. (9,882 different in the case of Vanguard’s 2050 fund for example). So you have the power of nearly every publicly traded company on the planet working for you.
  2. Every Sector: Tech, retail, health care, transportation, energy, etc are all represented. Instead of guessing which sector to invest in, a target date index fund removes individual sector risk by owning them all!
  3. Low cost: Mutual funds often have expense ratios of 1% and higher. Target date index funds have expense ratios generally around 0.15%. That may not sound like a big difference but over the course of your life it could save a quarter or more of your whole portfolio that would otherwise erode to fees.
  4. Auto-Rebalancing: These funds automatically rebalance themselves so you don’t have to worry about it. International stocks are way up while the US is down? It will rebalance to stay on the target asset allocation. Regularly rebalancing mathematically improves returns over time.
  5. Auto-Reallocating: As you get older, they automatically shift to more conservative investments to protect your nest egg and provide income in retirement.
  6. Eliminates guesswork: Even a simple three fund portfolio can have a lot of options. How much do you put in each fund. And when they perform differently, it can be tempting to change your mind and allocation. That jumping around is likely to hurt your long term performance. With a single fund, you dump everything in it, forget about it and you’re rich.
  7. Simplicity: With one fund, it makes your life simpler when deciding what to buy. This simple “set it and forget” mentality can help with bad human behavioral tendencies like chasing past performance and trying to time the market.

Throwing in more funds won’t make you more diversified or improve performance, it will just make you more likely to lose to the market over time. A single target date index fund guarantees you your fair share of the market and automatically manages risk over the course of your life.

A word of warning

Not all “target date funds” are target date INDEX funds. If you buy an “actively managed” target date fund, you’ll be paying much higher fees and will be very likely to lose to the market.

You can tell whether or not a target date fund is an index fund by looking for the word index in the name and by looking at the expense ratio. Index funds generally charge well under 0.5% (usually closer to 0.1%). Actively managed funds generally charge over 0.5% (usually closer to 1%)

Target date index fund with Low Fees

Target date index fund with high fees

So how do I buy one?

If you’re investing inside a 401k or 403b, your company may offer a target date index fund option. If not, your best bet is to buy and hold 2-3 individual index funds according to the rules on the home page, then roll over your 401k when you leave that company.

If you have your own IRA or brokerage account, then you need to look up the target date index funds offered with no load and no transaction fee by your brokerage. My favorite brokerages are Vanguard and Fidelity.

Which one do I buy?

To choose a target date index fund, first choose your brokerage from the chart below. Then take your birth year and add 65. For example, if you were born in 1980 and you use Fidelity: 1980 + 65 = 2045 (FIOFX).

Retirement Year Vanguard Fidelity Schwab
2020 VTWNX FPIFX SWYLX
2025 VTTVX FQIFX SWYDX
2030 VTHRX FXIFX SWYEX
2035 VTTHX FIHFX SWYFX
2040 VFORX FBIFX SWYGX
2045 VTIVX FIOFX SWYHX
2050 VFIFX FIPFX SWYMX
2055 VFFVX FDEWX SWYJX
2060 VTTSX FDKLX SWYNX
2065 VLXVX

Note that choosing an earlier year doesn’t mean you’ll get to retire earlier. It just means your investment will get more conservative earlier. If you want to be more aggressive with your investment you would actually do the opposite and pick a later year, but the asset allocations they have chosen at the given dates are reasonable and being realistic with your asset allocation timeline in is wise.

2 Likes

Thanks for posting this. A target date index fund sounds very promising. I looked into VTSAX, VFIFX and S&P 500. I know the target date index fund has a different fund make-up than VTSAX /S&P 500, as it consists of international stocks, and some bonds. So, I get VTSAX and VFIFX may not be ideal for side by side comparison.

Below is based on published data comparing the growth of a hypothetical $10,000 invested in 2010 til June '20:

S&P 500 Index - $37,030.98
VTSAX -$36,199.84
VFIFX -$26,169.17

image

Below are the expense ratios for VTSAX and VFIFX:
VTSAX - 0.04%
VFIFX - 0.15%

VTSAX has about $10,000 more growth and a lower expense ratio when compared to VFIFX. I understand and really, really like the idea of VFIFX automatically rebalancing and reallocating. You are right, it takes the guesswork away from me having to have the right balance of US stocks, international stock and bond fund and making sure that I make correct adjustments as I get older.

My question is, am I loosing out on potential growth if I go with VFIFX rather than VTSAX (and may be try to include some international stocks and bonds in my portfolio). Is this just too risky for me to try and do myself? Or at the end of the day, does it make more sense for me to go with a target date index fund and just assume in the future that this growth difference will be little.

Thanks! Wonderful community.

3 Likes

Hey @ChellH!

That’s a really good question. And smart, educated, experienced, altruistic people disagree on the answer.

But first, let’s examine why VTSAX outperformed the target date fund over the last 10 years. Those ten years started right at the end of the financial crisis when the US market was super low. What followed was 10 incredible years of US stock market growth. The US market was the best performing asset class by far. A target date fund is more diversified (as you mentioned) because it also contains international and bonds, which didn’t grow as fast during that time. So the diversification basically slowed it down this past decade.

So, for the last 10 years, for sure, you would have been better off being 100% US stock market. But that’s easy to know because those charts are readily accessible. What we really want to know is what’s going to happen the next 10 (or 50) years. That’s harder to know. For example, I could imagine reading a post 10 years from now that says something like “With China, Korea, Brazil and India outperforming the US stock market by so much, why would you ever want to invest in a target date fund that contains all those old slow growth US companies?” If you weren’t in international for those 10 years, you would have missed out on that exciting growth. (The same argument could be made for a down world market and bonds outperforming).

I like having the international component, even though the most recent decade doesn’t prove my point.

Here’s a good thread on the same US vs International debate that gives a pretty good breakdown of both sides:

But if you wanted to go 100% VTSAX I wouldn’t try and stop you. I would, however, suggest that you pick a strategy and stick with it. A lot of oscillating back and forth based on what the market is doing is likely to lead to “chasing past performance” where you go and buy what just did well, and always miss out on what’s about to do well, thus underperforming either strategy.

Thanks for the question and the kind words about the community! :slight_smile:

3 Likes

Thank you so much for this post! I like the idea of target date funds for the convenience of rebalancing and reallocation. I do have a question. If my 401(k) is with Vanguard 2055, but I’m targeting to RE closer to 2045, would maxing my Roth IRA in a 2045 fund be beneficial/wise?

Hey @jnelmo!

In my opinion, no. Stick with the 2055 fund. It has more to do with how long you’re going to live than when you stop working. And if there’s one fair critique of target date funds, it’s that they get too conservative too early. You can fix that by simply picking a later date, so your portfolio stays more stocks for longer. I think if you never invest a penny in anything other than the Vanguard 2055 fund, you will do great! :slight_smile:

2 Likes