A reader writes in, asking:
“One thing I don’t understand about target date funds is the implicit assumption that the only thing that should determine your asset allocation is how old you are. Doesn’t this seem like an obvious mistake?”
I’m not sure I’d say it’s a mistake how target date funds are constructed. But I absolutely agree that there’s more to risk tolerance and asset allocation than just the year in which you plan to retire.
For example, how stable is your income? A person with a secure, steady-paying job can take on more risk than a person with a job that could be lost at any minute or a person with a job that pays entirely based on commission.
What other assets do you have? If you have a very large emergency fund that you’re not counting as part of your portfolio, you can take on more risk in the portfolio than somebody with a smaller emergency fund.
What other assets would you have access to, if the need arose? Consider two young investors. One comes from a poor family and knows with 100% certainty that she wouldn’t be able to get any sort of financial assistance from friends or family if she lost her job. The other comes from an upper middle class background and knows that the Bank of Mom and Dad would chip in (at least to some extent) if a financial emergency came up. All else being equal, these two investors have very different levels of risk tolerance.
How much investing experience do you have? Have you been through a bear market before? Until you’ve experienced one, you should assume that it will feel worse than you’d naturally expect. If your portfolio is small relative to the size of your total available assets and you can therefore afford to make a mistake (e.g., sell out at or near the bottom in the event that you can’t handle the stress), then go ahead and build a high-risk portfolio. But if selling out would be a problem and you’ve never been through a bear market, you should probably consider a less risky allocation.
Do you have any need for the higher expected returns that come from a risky portfolio? For example, author/advisor Larry Swedroe has often written that he has a “low marginal utility of wealth” (marginal utility being the additional happiness you would get from more of the item in question), meaning that he has little to gain from a high-risk portfolio. Or, as Bill Bernstein puts it, ”if you’ve won the game, why keep playing?”
Target Retirement Funds and Risk Tolerance
Due to all of the above factors, an investor might want an allocation that doesn’t vary solely with age. For example, for a young investor who has a relatively low risk tolerance and who doesn’t expect that risk tolerance to change any time soon, a fixed 60% stock, 40% bond allocation may be a good fit. But the Target Retirement funds don’t offer that option. For investors who want an allocation that doesn’t vary with age, and who still want the simplicity of an all-in-one fund, Vanguard’s LifeStrategy funds can be a good fit.