Index Funds Vs Target-Date Funds: How Can You Decide Which Is Right For You?

[clatoden99]

How much time do you want to spend dealing with your investments? Target-date funds are designed to manage your portfolio with minimal hassle for many years. But they come with a cost. Are they a good choice for you? Preferably an index fund?

[disneysteve]

I would start by saying your question is faulty.

Most target funds that I'm aware of ARE index funds. They aren't made up of a single fund, though, but rather a basket of index funds covering a diverse spread of investments.

The point of the target fund is instant diversification and automatic risk-adjustment as you get older.

You can easily do it yourself by investing in 3 funds on your own. The problem is that when you are first starting out, you may not have enough money to diversify. Vanguard, for example, has a $3,000 minimum investment so if you only have a couple thousand dollars, you can only get into one fund. With the target fund, you could get the broad diversification from day one for the same money.

[disneysteve]

The primary argument against target-date funds is the underlying cost of the investment.

Target date funds offer professional management.

Neither of these statements is true.

[BuckyBadger]

Target date funds allow you to use index funds but not have to worry about rebalancing yourself or worry about gliding to a more appropriate (i.e. conservative) asset allocation as you approach retirement age. They are slightly more expensive than the underlying funds because of this feature. (Slightly for Vanguard, at least, but in general still much less than managed funds.)

If you have only a few accounts they are perfect. For example, when my husband and I had only Roth IRAs through Vanguard they were both in target date funds and everything was easy.

Once we both had 401ks it became more difficult to keep track of my overall asset allocation since the target date funds available in the 401ks weren't identical to the Vanguard ones. If I didn't care very much it probably still would have been good enough and served its purpose.

That's where index funds come into play. With only three index funds (Total US Stock, Total International Stock, and Total US Bond) and an understanding of your own risk tolerance as you get closer to retirement, you can achieve the same end result as a target date fund while taking advantage of the lowest-cost funds that are available to you.

[Jluke]

That's where index funds come into play. With only three index funds (Total US Stock, Total International Stock, and Total US Bond)

Are you referring to ETF's like VTI and VXUS or the mutual fund versions?

If it is in a ROTH account is it better to have the mutual fund or the ETF? I ask b/c the mutual fund would pay out capital gains, etc whereas the ETFs only pay dividends. And in a ROTH, taxes do not matter.

[BuckyBadger]

I do not use ETFs and can't speak to their benefits or drawbacks.

[autoxer]

The reason I choose the target date fund, is because I don't want to worry about rebalancing. The simplicity is more valuable to me right now, then the ability to tweak the asset allocation. Since it is comprised of index funds, the cost isn't a deterrent either, but I know not all target date funds are created equal, check the expense ratio before you buy.

[clatoden99]

I would start by saying your question is faulty.

Most target funds that I'm aware of ARE index funds. They aren't made up of a single fund, though, but rather a basket of index funds covering a diverse spread of investments.

The point of the target fund is instant diversification and automatic risk-adjustment as you get older.

You can easily do it yourself by investing in 3 funds on your own. The problem is that when you are first starting out, you may not have enough money to diversify. Vanguard, for example, has a $3,000 minimum investment so if you only have a couple thousand dollars, you can only get into one fund. With the target fund, you could get the broad diversification from day one for the same money.

Thanks, but what i know about target date date fund is: The most powerful use of target date funds is to create desired cash flow over time, calculate net present value in 5 year increments and create a ladder of target date funds

[BuckyBadger]

Thanks, but what i know about target date date fund is: The most powerful use of target date funds is to create desired cash flow over time, calculate net present value in 5 year increments and create a ladder of target date funds

Say what now?

[dczech09]

Index funds are mutual funds (open-ended funds) that invest in such a manner that they track a market index such as the S&P 500. This means that they track an index and operate with the market, as opposed to trying to beat the market. As a result, they tend to have lower costs associated with them.

Target-date funds are sometimes referred to as "fund of funds." These are mutual funds that invest in other mutual funds (largely index funds). They seek to create automatic diversification, and apply an asset allocation appropriate based on a preset investment horizon. So as the investors get older, the investment mix becomes more conservative.

Both can be great options, but the question is how can you decide which is right for you.

Index funds are great for people who...
- Want to keep costs low
- Do not mind performing with the market

Target-date funds are great for people who...
- Want to be hands-off with their investments
- Are beginners and do not have a lot of funds

I personally do not have any money (directly) invested in index funds. I have considered it, but I have found mutual funds with better historical performance. I do pay more for these funds, but the return potential is greater (it is a risk/trade-off I am willing to accept).

I do recommend target-date funds for people starting out. Like disneysteve pointed out, Vanguard has a $3,000 minimum investment. I use T Rowe Price which has a $1,000 minimum investment. If you do not yet have thousands of dollars to invest, you can only get one mutual fund (or a few). So using a target-date fund is a great place to start.

My strategy is that my Roth IRA contributions go directly into a target-date fund. Once I have accumulated some good money in that fund, I will take a chunk and put it into a different mutual fund. When I first started out, I only had the target-date fund. Now, I have several mutual funds within my Roth IRA.

It is all about preference!

[disneysteve]

Like disneysteve pointed out, Vanguard has a $3,000 minimum investment.

However, the minimum for their Target funds is only $1,000. That makes them a great starting point for people. Rather than needing $3,000 to invest in any of the individual funds that make up the Target fund, with just $1,000, you can have a piece of all of them.

Also, I don't believe Vanguard adds any additional expenses with the Target funds. You pay the ERs of the component funds. If anyone knows this to not be true, please post a link to the info.

[FLA]

I read that when they started out, after a while it turned out many Target Date Funds were not invested aggressively enough. I did not like the Target Date Fund choices at all, the portfolios were less aggressive than I was used to and my company charged higher fees for these funds. That was a long time ago but it made me stick with Index Funds. If bought through my 403b, there was no minimum with Vanguard or Fidelity. I rarely had to even re-balance and was pretty hands off. Worked out ok for me.

[clatoden99]

Index funds are mutual funds (open-ended funds) that invest in such a manner that they track a market index such as the S&P 500. This means that they track an index and operate with the market, as opposed to trying to beat the market. As a result, they tend to have lower costs associated with them.

Target-date funds are sometimes referred to as "fund of funds." These are mutual funds that invest in other mutual funds (largely index funds). They seek to create automatic diversification, and apply an asset allocation appropriate based on a preset investment horizon. So as the investors get older, the investment mix becomes more conservative.

Both can be great options, but the question is how can you decide which is right for you.

Index funds are great for people who...
- Want to keep costs low
- Do not mind performing with the market

Target-date funds are great for people who...
- Want to be hands-off with their investments
- Are beginners and do not have a lot of funds

I personally do not have any money (directly) invested in index funds. I have considered it, but I have found mutual funds with better historical performance. I do pay more for these funds, but the return potential is greater (it is a risk/trade-off I am willing to accept).

I do recommend target-date funds for people starting out. Like disneysteve pointed out, Vanguard has a $3,000 minimum investment. I use T Rowe Price which has a $1,000 minimum investment. If you do not yet have thousands of dollars to invest, you can only get one mutual fund (or a few). So using a target-date fund is a great place to start.

My strategy is that my Roth IRA contributions go directly into a target-date fund. Once I have accumulated some good money in that fund, I will take a chunk and put it into a different mutual fund. When I first started out, I only had the target-date fund. Now, I have several mutual funds within my Roth IRA.

It is all about preference!

I really love your piece but then how Can you hold firm during troubled markets?

[corn18]

I really love your piece but then how Can you hold firm during troubled markets?

The answer to this is to pick an asset allocation that matches your risk tolerance. I have chosen 60% stock and 40% bonds as my asset allocation. 10% of the stock is international. I keep the bonds in tax sheltered accounts (401k and IRA's) for tax purposes. I put the stocks (all index funds) in in my taxable account. When the market took a dive this year, it was easy to stay the course because I trust my asset allocation. I could go more aggressive because I have a pension and health care for life through the military, but I am not comfortable with a more aggressive allocation. It is really quite freeing when you go through the process of picking an asset allocation based on risk tolerance and then execute it.

This is a good read on asset allocation and how to determine what is right for you:

https://www.bogleheads.org/wiki/Asset_allocation

Tom

[disneysteve]

The primary argument against target-date funds is the underlying cost of the investment.
Target date funds offer professional management.

Neither of these statements is true.

Can you explain please?

Sure.

Target funds don't cost any more than the underlying funds do individually, at least not at Vanguard.

Target funds, at least at Vanguard, are index funds. They aren't professionally managed. They are passive investments.