Target Date Retirement Funds Pros and Cons

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Target date funds have been around for two decades now and they continue to evolve and find their place in more and more portfolios. The funds are typically inexpensive and give you a great amount of diversification while targeting an appropriate amount of risk to fit your financial timeline.

When target date funds were introduced they were designed for 401k plans as an end-all-be-all investment for participants. Now these investments seem to make their way into most portfolios, across multiple accounts, and sometimes appear as a single investment in an entire portfolio. Target date funds are actually very versatile, becuase these funds follow a “glide path.” This basically means that, as the target date approaches, the funds’ allocation tends to glide down a path to a more conservative allocation. Since their introduction, target date funds have become more efficient, more affordable, and more diverse.

To show how popular these investments have become, consider this, in 2013, 1/3 of net flows to mutual fund companies have been into target date funds. Check out the statistics for the three largest target date fund companies in the market:

Percentage of net flows that are invested in target date funds:

Fidelity:                50%
Vanguard:            16%
T. Rowe Price:     95%

Since the great recession, most target dates funds accelerated their downward glide path to a more conservative allocation. Pre-2008 equity exposure for close-to-retirement based funds have seen decreases in equity exposure from upward of 50% down to 35%. We have seen this trend of target date funds that are within 5 years of their target becoming much more conservative, with the exception of the Fidelity Freedom Funds, who have increased equity exposure from their previous norms.

Brian and Bo love target date funds when starting out, because of the ease and sophistication that comes in one holding. At some point, though, when you start adding multiple accounts, larger amounts of money, and bigger tax implications, more advanced planning is advantageous.

ConsumerReports did a great article on how to select the optimum target date fund for your situation. Most of the data in the show comes from Morningstar’s annual target date webinar and their 2014 Target Date Series Research Paper.

Dollar Cost Averaging…The Discussion Continues

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This week Brian and Bo dig into the dollar cost averaging discussion, and illustrate the pros and cons that DCA presents. The Dollar Cost Averaging strategy is fairly simple, it boils down to having systematic entry points into the market.

Investopedia defines dollar cost averaging as a technique of buying a fixes dollar amount of a particular investment on regular schedule, regardless of the share price. More shares are purchased when prices are low, and fewer shares are purchased when prices are high.

While domestic equity markets are consistently reaching higher highs and setting higher lows people are asking what our strategy is moving forward. The answer is still the same: make a plan, keep it simple, and make it automatic. Dollar Cost Averaging helps address these concerns in up and down markets. Additionally, dollar cost averaging is a great technique to use to stick to your plan so that you stay in game during bad markets when dollars are most valuable. It works especially well in markets that are a little more volatile, but that is not to say go and throw all your money in micro-cap emerging market holdings. You must keep transaction costs, diversification, asset allocation, and asset location in mind when executing this strategy.

Conversely, there have been more than a few research papers written on this topic, about as many people seem to like DCA as the amount of people that do not. Vanguard jumped on the train in 2012 with their research report, Dollar-cost averaging just means taking risks later. Their research is based around the fact that, historically, markets increase 2/3 to 3/4 of the time and they go on to use this data to convey that lump sum investing should outperform DCA during the same amount of time. Vanguard’s research also illustrates that lump sum investing outperforms DCA on an average of 2.3% on average over every 10 year cycle they included in their study.

If 2.3% less in returns on a 10 year basis is the cost of taking a portion of your portfolio off the table for the 1/3 to 1/4 of the bad time, it does not seem like too big of a price to pay. We like to think of it as insurance against down markets, specifically when markets are in their current condition. A New York Times article by Paul Sullivan in 2011 used a few lines to portray the biggest benefits of DCA, that the person who put money in slowly was still better off than the person who tried to guess the direction of the market.