When you see your net worth drop precipitously, it's easy to blame bad luck on your investments. But that doesn't mean you should give up a smart investing strategy that will prove successful in the long run.
Hitting the target
For example, take an investment that has gotten particularly popular in recent years: the target-date mutual fund. Target funds are designed to make investing as easy as possible. The general idea is that each fund has a target date associated with it that's supposed to correspond to when you expect to reach your financial goal, such as your planned retirement date.
The general strategy that target funds use fits well with most people's financial planning. When there's still a long time before you need your money, you can afford to take more risk. So longer-dated funds invest your money aggressively at first, with large percentages in stocks and little or no investments in bonds or cash. As you approach the target date, however, the fund shifts more of its money toward conservative investments, reducing the risk level of the fund's portfolio and making it more appropriate for your shorter timeframe.
To see how that operates in practice, take a look at two different target funds from Vanguard: the Target Retirement 2020 (VTWNX) and 2040 portfolios:
|
Target Fund Holding |
Holdings Include ... |
% of 2020 Fund Invested |
% of 2040 Fund Invested |
|---|---|---|---|
|
Vanguard Total Stock |
ExxonMobil |
55% |
72% |
|
Vanguard European Stock |
GlaxoSmithKline |
7% |
9% |
|
Vanguard Pacific Stock |
Toyota Motor, BHP Billiton |
4% |
5% |
|
Vanguard Emerging Markets |
Petroleo Brasileiro |
3% |
4% |
|
Vanguard Total Bond |
Treasury, agency, and corporate bonds |
31% |
10% |
Sources: Vanguard, Morningstar.
With 10 years to go, the 2020 fund doesn't have to be completely conservative. But it takes a far less aggressive approach than the 2040 fund, which sports a 30-year time horizon that allows investors to take greater risks and wait out any downturn.
How target funds failed investors
When stocks were performing well, target funds did their jobs admirably. In 2008, however, when the stock market tanked, many investors were shocked to find that their target funds lost substantial amounts of value. In particular, even those funds with target dates of 2010 still had fairly large allocations to stocks -- in some cases, more than 50% of the portfolio.
Apparently, many investors didn't understand just how their target-date funds worked. Some undoubtedly believed that when the target date was reached, their fund would no longer own any stocks at all, and would instead have all its assets invested in ultra-safe investments like cash or short-term bonds. As they saw it, there would be no reason for a 65-year-old to have any of their money exposed to the risk of the stock market.
Yet in reality, that's an overly simplistic way to look at the problem. It's true that when you retire, the demands you place on your investment portfolio to generate income increase greatly. Yet except for those who've been particularly successful in accumulating wealth throughout their careers, most investors can't afford to stand pat on their nest eggs. Instead, they need additional growth -- and the best place to get that growth is the stock market.
Correcting the mistake
In response to their unexpected losses, some investors simply gave up on target funds entirely. Doing so, however, simply discarded a completely valid investing method solely because of the market's huge bear market drop. Moreover, those who retreated to "safer" investments missed out on the market's rebound, which has helped many target funds recover much of their losses from last year.
The mistake that most people made wasn't in using target funds. Instead, they should have understood the risk they were taking. If you not only understood but also embraced that risk and have held on despite the downturn, then you can feel confident you've done everything you can to earn yourself a prosperous retirement.
