When you're setting up your investment choices in your 401(k), you're generally given three main options: your employer's stock (if it's a public company), funds put together by market cap, and target-date funds. Target-date funds are investments that cater to your projected retirement year. As you get closer to the target date, the fund automatically tweaks its holdings to become more conservative.
Target-date funds have grown a lot in popularity over the past few years. In 2021, the total amount invested in target-date funds hit a record $3.27 trillion (up 20% from 2020), according to Morningstar's Target-Date Strategy Landscape Report. Target-date funds can be a good option for investors looking to be hands-off with their portfolio, but they do come with a price.
Since they reallocate their holdings for you, target-date funds tend to be costlier than other index fund options. It's not farfetched to find a target-date fund with an expense ratio of around 0.50%, meaning it'll cost you $5 for every $1,000 you have invested. While that might not seem like much, that could add up to tens of thousands in fees paid over the life of a 401(k).
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Taking out the middleman
There are four main types of assets in a target-date fund: U.S. stocks, international stocks, bonds, and cash. For stocks, most target-date funds are "funds of funds," meaning they consist of other, typically much cheaper, funds. Instead of paying the expensive fees that often come with target-date funds, you can remove the middle man and just invest in what the target-date fund holds. For a good, well-rounded retirement stock portfolio, you only need four types of funds: large-cap, mid-cap, small-cap, and international.
Large-cap funds consist of larger companies that are typically more stable because they have more resources to their advantage. You probably won't see outlandish growth from large-cap funds because of their size, but they've proven more reliable over time. Small-cap funds are on the opposite end of the spectrum. They're smaller companies with high growth potential, but they're more prone to volatility and less likely to make it through rough economic times. Mid-cap funds represent the sweet spot: small enough for high growth but large enough to carry less risk.
International funds consist of non-U.S. companies and should be a part of anybody's portfolio. If you're only investing in U.S. companies, you're limiting your return potential and aren't as diversified as you should probably be. A good rule of thumb is to have around 20% of your portfolio in international stocks.
Handle your own stock reallocations
Adjusting your portfolio risk profile as you age is important in investing. You don't want to take on too much risk close to retirement in case something goes wrong (like a bear market), and you end up being unable to financially recover. In your younger years, the vast majority (if not all) of your portfolio will be in stocks. As you near retirement, your portfolio will begin to incorporate safer assets like bonds and cash.
Fortunately, you don't have to pay high fees to have target-date funds to reallocate for you; you can do it yourself. For someone in their 20s or 30s, you can take on more risk, so your allocations might be 80% to 90% in stocks with an allocation such as:
- Large-cap: 50%
- Mid-cap: 15%
- Small-cap: 15%
- International: 20%
If you're in your 40s, you still have around two decades before retirement, so you don't have to become too conservative just yet. Your allocations may be 30% to 40% bonds with the remaining allocation of stocks broken down as:
- Large-cap: 60%
- Mid-cap: 10%
- Small-cap: 10%
- International: 20%
As you enter your 50s and your final decade or so before retirement, you want your large-cap stocks to lead the way. You still want to grow your money, but you also want stocks that are typically more stable and can help with at least preserving what you've made up to that point. Your portfolio may be 40% to 50% bonds, 10% cash, and the rest split up among:
- Large-cap: 70%
- Mid-cap: 5%
- Small-cap: 5%
- International: 20%
There is no one-size-fits-all approach when it comes to your allocations. You can start with these baselines, but adjusting them depending on your personal situation and risk tolerance is important. You can be in your 30s and decide you're risk-averse and prefer much less exposure to small-cap stocks, or you can be in your 50s and be comfortable with more high-risk, high-reward stocks in your portfolio.
Whatever the case, do what makes you feel comfortable. By taking just a few minutes every year or so to adjust your allocations, you can potentially save yourself thousands over time.
