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This Is Everyone's Favorite Investment Again

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This time last year, everyone was screaming bloody murder over an investment vehicle that had seemingly put investors' life savings at risk. Now, though, the stock market rally has given those investors the bailout of their dreams, and what was once loud criticism has subsided as people have gotten their money back.

Target funds: no longer a target?
The investment that had everyone in an uproar last year was the target date retirement fund. These funds were designed to be simple ways for investors to get everything they needed to reach their financial goals in a single investment.

Combining a variety of stocks, bonds, and other types of assets, target funds got their name from the fact that the funds chose investments based on the assumption that investors would need to start drawing money from the fund on a particular date. For instance, if you knew you wanted to retire in 2025, then you could pick a 2025 target fund. Target funds promised to give investors a diversified portfolio whose risk levels would diminish automatically as the target date approached.

Unfortunately, the amount of risk that some target funds took didn't decrease as quickly as some investors thought they should. Several target funds for those retiring in 2010 lost 20% of their value or more in last year's plummeting stock market, even though the target date was just two years away. Contributing to the large declines, many of those funds had 50% or more of their assets in stocks. In response, it appeared that the government might step in to force target funds to take less risk.

Back on target
Now, though, the rebound in stocks has helped target funds regain some of their lost glory. Vanguard's 2010 target fund, for instance, now has a slight positive return over the past three years, thanks largely to strong performance from that high allocation to stocks. Given Vanguard's index-based approach, large-cap domestic stocks such as Apple (Nasdaq: AAPL  ) , Google (Nasdaq: GOOG  ) , and IBM (NYSE: IBM  ) , which have done extremely well, played a big role in the target fund's overall performance.

But you'll find great performance by stocks outside the U.S. as well. As part of Vanguard's European-based international component, Rio Tinto (NYSE: RTP  ) and Barclays (NYSE: BCS  ) have helped drive performance; in addition, Vanguard's Pacific Rim Index Fund has similarly performed quite well.

Lastly, those target funds that have exposure to emerging markets have generated some extraordinary returns. Fidelity's 2010 fund, for instance, has only a small allocation to emerging markets, but what it does own has risen by 50% so far this year, with stocks such as Vale (NYSE: VALE  ) and Infosys Technologies (Nasdaq: INFY  ) powering its portfolio higher.

Toning down the risk?
Now that at least some near-term target funds have made their investors somewhat whole again after the bear market, the bigger question is whether the funds are everything they're cracked up to be for long-term investors. Many were surprised at how much they lost during the bear market, but given that each fund's holdings and allocation strategies were all publicly available, you could have seen exactly what each fund was doing before the bear market hit. Yet some people made incorrect assumptions based on what they thought the funds should have done rather than looking at what they were actually doing.

Fortunately, though, if you're uncomfortable with the control that target funds have over your money, there's a pretty easy fix: Take control yourself with your own asset allocation. The Vanguard target fund, for instance, is just a combination of six different stock and bond funds. If 50% in stocks is too high for your taste, then simply ratchet down the amount you dedicate to stock funds, and send more to a bond or cash fund.

Sure, you'll have to do a little legwork adjusting your portfolio from year to year to keep risk where you want it. But doing that extra work is a lot better than being uncomfortable with a target fund's choices.

Nevertheless, the fact that target funds have recovered so well may make them your favorite investment again. That's not a bad thing, as long as you understand the risks involved and are comfortable with them.

Want more tips on how to invest for your retirement? Our Rule Your Retirement newsletter service can point you in the right direction. Start your free 30-day trial today.

Fool contributor Dan Caplinger is enough of a control freak not to like target funds, but he still likes the concept. He doesn't own shares of the companies mentioned in this article. Google is a Motley Fool Rule Breakers recommendation. Apple is a Stock Advisor selection. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy wants to be your best friend forever.


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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