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December 23, 2019

Target Date Funds: What They Are & How to Make Your Own

Target date funds. They’re investment packages sold to investors as simple solutions to a lifetime of investing. But what exactly is a target date fund? And why would you want to design a custom one for yourself?

What’s a Target Date Fund?

A target date fund is an investment strategy that changes your asset allocation between high risk and low-risk investments based on your age or a specified target date. They usually take you from a higher risk position in the earlier years to a lower risk position as the target date comes closer.

Why it Works

It works because it’s mostly automatic and you don’t have to actively make decisions. It’s a long-term plan that you only have to make once and then revisit every now and then to rebalance and decide if it still aligns with your risk appetite.

When you’re young and your investment horizon can still be measured in decades, you’re in the wealth accumulation phase. You can take a lot more risk and your target date fund should reflect that and put more emphasis on investing in stocks and index funds.

In your more advanced years, you’re more concerned about preserving your accumulated wealth and you’re in the wealth preservation stage. When you reach that age, a target date fund will allocate a larger portion of your portfolio into safer investment vehicles like cash equivalents and bonds.

This is also reflected in funds with a specified target date. Higher risk in the earlier parts of the timeline and lower risk as you progress to the end.

Who is it For?

Target date funds were designed with particular types of investors in mind.

  1. Passive Investors
    These are investors who don’t really care about actively watching the market and constantly making investment decisions. They’d much rather sit back and let the money (and someone else) do the work.
  2. Investors With an Average Risk Tolerance
    If you find that your risk tolerance is similar to the average person, then target date funds might be for you. Target date funds are not a good fit for aggressive or defensive investors.
  3. Long-term Investors
    These are investors who don’t really see themselves touching their investments for a long time. These funds usually have a minimum of a 10-year investment horizon.
  4. Investors Looking for a One-fund Solution
    If you like to keep things simple and would prefer to invest in just one thing forever, then this might be for you. If you choose a target date fund that is based on age, then that’s a single investment for your lifetime.

Why Make Your Own?

Although target date funds are great in that they’re an easy, simple solution for people who can’t be bothered to spend time investing, there are a few drawbacks in choosing factory-made target date funds.

Disadvantages of a managed target date fund

  1. Higher fees
    Target date funds are managed funds and with management comes management fees. It will differ per fund but don’t expect to find extremely low fees like in index funds. 

    You’ll also discover that some of these target date funds actually have index funds as part of the underlying fund structure. So that’s part of your fee going straight to the investment company without them doing any additional work.

  2. Little control
    These are predesigned investment strategies. You can pick which fund you invest in but nothing much else past that. You will have little control over any decisions aside from how much you put in.
  3. Difficult to customize
    Target date funds usually invest in other funds themselves such as index funds and bond funds. But you can’t really pick which underlying funds it will buy into. The best thing you can do is to research a ton of target date fund and then pick the one that best aligns with what you want.
  4. Preset life stages and timelines
    These funds will not budge based on your circumstance or personal preference of when to change allocations.

Making Your Own Target Date Fund

If you find that none of the existing target date funds fit your requirements or if any of the disadvantages above turned you off to factory-made funds, then why not try making your own target date fund?

Although it will be a tad more involved, you get much more flexibility and control of your money. Plus, you can extend your investments to things other than traditional investment vehicles.

There are a few advantages to making your own target date fund.

Advantages of DIY

  1. Pick and choose
    You can pick and choose funds that you prefer. You have the full gamut of the market to choose from. Though some might find this daunting, it’s great for investors who like knowing where exactly their money is going.
  2. You can pick index funds.
    A lot of these pre-made target date funds also invest in index funds. If you DIY your own, then you get all the advantages minus the management fees.
  3. Small fees
    If fees are a concern for you, and they should be, having the freedom to choose where your money goes also allows you to choose what fees you need to pay.
  4. You can select life stages and timeline
    Each person has a different life story and there’s no one size fits all investment horizon. You can also account for big life events like having a child or buying a home.
  5. Great for early retirees OR aggressive investors
    There are more and more people going outside the stereotypical retirement timeline of working until the government prescribed retirement age.

    People are retiring early, not in small part to the growing FIRE community.

    When you DIY, you can pick a more aggressive timeline and you don’t have to follow the gradual change in allocation found in target date funds.

  6. Alternative investments
    Target date funds usually involve traditional investment vehicles like stocks and bonds. If you DIY, then you can invest in an assortment of alternative investments. Real Estate, Art, REITs, you name it.

The whole point of having a target date fund is to have a long-term plan for your investments. When it’s your own plan, anything goes.

How to Make Your Own Target Date Fund

If you think making a custom target date fund is for you then here are some simple steps to do it.

  1. Get an outline from an existing target date fund
    Do your research and get a baseline feel for what a target date fund is and what traditional timelines and allocations usually look like.

    This is extremely helpful if you’re just starting out investing.

    It can also be helpful to look at the underlying funds that the target date fund is composed of. You’ll be surprised to find a lot of overlap between funds from different companies.

  2. Choose your life stages or investment timeline
    Here’s where you lay out the rough outline of your investment life. You can base it off of the premade funds or make your own.
  3. Choose your allocation for each life stage or chunk of time
    Pick an allocation that feels right for you in each stage of your target date fund. You can divide it between growth (stocks, index funds, REITs) and defensive (cash equivalents, bonds, CDs) investments.
  4. Put your allocated percentages into an index fund and a bond fund.
    If you’re just starting out then you can start out with just investing in two funds. If you’re feeling more adventurous then feel free to expand beyond that. As long as you follow your allocation percentages between growth and defensive investments.
  5. Rebalance each year
    The dollar value of your portfolio will change every day. It can be helpful to check once a year to make changes and reallocate according to your plan.
  6. Adjust your allocation as you progress to a different stage in your plan.
    Then just set some reminders to reallocate your investments when the time comes to do so.

Is a Target Date Fund For You?

Whether you pick a premade Target Date Fund or make your own, you can’t go wrong with either as long as you follow the plan. It’s a great way even for beginner investors to get started without doing a ton of research. What’s important is that you start.

“The best time to plant a tree was 20 years ago. The second best time is now.”

– Chinese Proverb

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