Don't Repeat This 2008 Mistake

For those looking for a one-stop investment solution, target funds got billed as the perfect way to save for retirement or other long-term goals. Yet judging from their performance this year, investors who relied on target funds to get their allocations right got a nasty surprise.

Along with most other mutual funds, target funds have suffered this year as the stocks they held lost a big chunk of their value. Yet while the fact these funds lost money isn't shocking, the size of those losses is -- especially on funds that were supposedly for more conservative investors.

Way off-target
Just look at the results from a few selected target funds:

Source: Morningstar. Returns as of Dec. 18.

As you can see, the stocks these funds hold aren't anything particularly risky. All of these target funds buy shares of other mutual funds from the same company in order to implement their allocation decisions. They tend to own well-diversified portfolios with various types of stocks and bonds, including large-cap and small-cap companies, as well as domestic, international, and emerging markets stocks.

Too much of a bad thing?
Where the funds surprised some investors, however, was in the amount of stocks and bonds they held. Take a look at the allocations on these funds:

Source: Morningstar.

At first glance, you'd think these stock allocations were way too high for someone planning to retire in just a couple of years. Some rules of thumb for investing would suggest a much more conservative portfolio, perhaps a third in stocks with two-thirds in bonds and cash. So what were these funds doing with half or more of their assets in the stock market?

A strategy for longevity
For an answer, you have to look at the basic strategies those fund companies use for their target funds. At Vanguard, even the Retirement Income Fund -- the most conservative fund Vanguard offers in the series, which the company would recommend to those who are already retired -- has almost 30% exposure to stocks. Similarly, Fidelity's Freedom Income Fund -- designed for those who retired before 1998 -- has 20% allocated to stocks.

Having that much money in stocks at that age may sound crazy. But in an environment where many stocks are yielding as much as or more than bonds, retirees seeking income have increasingly looked to the stock market for attractive dividend stocks.

The fact is if you need your income to grow steadily during a retirement that could last 30-40 years, you need to own stocks. Bonds by themselves simply can't deliver unless you've got an extremely large nest egg. Especially for those near retirement who got a late start in saving for their golden years, the potential growth that stocks provide is essential to give you a chance at a steady standard of living after you retire.

Know what you own
Again, these drops would have come as no surprise to anyone who understood the strategy these funds followed. But if you only look at the name of the fund and assume you know how it will work, then surprises like this can leave you unprepared.

If you don't agree with the strategy target funds use, you can do one of two things. You can use a more conservative target fund, even though the date may not match up with your goal. Alternatively, you can create your own asset allocation, perhaps using the same component funds that the target funds themselves use. Either way, don't just blindly accept what a fund company gives you -- make sure you get what you want.

For more on retiring well, read about:

• How to save your 401(k) before it's too late.
• Isn't it time to start getting rich?
• Secret disasters that lurk within your portfolio.