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Jerry Citarella: Target date funds can offer appropriate risk

Financial Truth

Posted: April 17, 2012 1:55 a.m.
Updated: April 17, 2012 1:55 a.m.

In last week’s column, I discussed company-sponsored retirement plans. This week, I thought I’d help you understand a type of investment option that’s become common within these types of plans.

If you’re a participant in your company’s plan, there’s a good chance you have target-date funds as options for your assets. Many mutual fund companies have created them, partially as a way to help investors avoid some of the biggest mistakes commonly made, but there’s still confusion about how they work.

Target-date funds may have different names or be referred to as something altogether different, such as retirement date investments, but all the options are basically designed the same. They won’t be set up exactly the same from company to company and they definitely won’t have the same underlying investments, but structurally, the concept is simple and similar.

The target-date funds are designed to give investors a diversified investment option with risk that’s perceived as appropriate for a specified time horizon.

In theory, the longer the time period (target date), the more aggressive the portfolio. Most, if not all, also adjust and become less aggressive as the target date approaches. They create a portfolio based on a risk profile and adjust accordingly.

In my opinion, the best feature of most of these plans is regular and consistent rebalancing.

Many investors do what’s commonly referred to as “setting it and forgetting it.” This means they set up a portfolio of investments and initially have some awareness of asset allocation and risk that can be created or eliminated using various types of assets.

You’ve probably seen the pie charts with different colors or actual asset-classes listed showing different percentages in each. Based on what’s deemed appropriate, the initial portfolio is set up. Very often the percentages are never again adjusted, which can create more risk in the future.

I’ll spend more time on this topic in another column, but here’s the simple explanation:

Let’s assume you have two holdings, one aggressive and one conservative, and you hold them equally at 50 percent each. It would be rare and, in fact, nearly impossible for both holdings to have the exact same growth over an extended period of time.

What does this create? It creates a portfolio that is now out of balance with the original portfolio mix.

If the more aggressive portfolio does better, it could now be at 55 percent of the holdings, while the more conservative portion is now only at 45 percent.

What has this done? It’s made your overall portfolio more aggressive by exposing you to a higher percentage of the aggressive holding.

If you’ve become more aggressive, then this could be fine, but if your risk tolerance hasn’t changed, something needs to be done.

The answer? Rebalance the portfolio, returning it to its original state. There are other benefits to rebalancing, but the greatest is keeping things the way they were intended to be.

Many portfolios are never rebalanced, causing all kinds of problems.

Target date portfolios will do this for you automatically at regular intervals. This simple technique has been proven to substantially reduce downside risk. It’s great when you don’t have to worry about it on your own anymore.

The initial setup of target date funds is also helpful. They’re designed by the mutual fund company to give you a preset allocation of some, or many, of their individual funds.

The company determines which funds will be best suited to create the desired allocation and risk. They will also use the funds perceived to be their best choices and make changes when necessary.

It eliminates a lot of the guessing typical investors sometimes use. It also uses portfolio mixes that have been proven successful.

As I mentioned earlier, these portfolios will adjust accordingly as they get closer to the target date, becoming less aggressive. This, in addition to other features, can make these plans valuable tools.

I won’t say they’re right for everyone, but if you don’t know anything about this topic or you know you will not monitor and adjust your holdings appropriately, they’re a great default option that gives many people a better chance at success.

Jerry Citarella is the owner of Infinity Wealth Management 23734 Valencia Blvd., Suite 301, Valencia, 661-255-9555, ext. 11.  He is also the author of The Truth Helps Series of financial planning books. Citarella’s column reflects his own views and not necessarily those of The Signal. Submit questions to:  Securities and investment advisory services offered through NEXT Financial Group, Inc. Member FINRA/SIPC.  Infinity Wealth Management is not an affiliate of NEXT Financial Group, Inc.


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