If you’ve had a 401(k) plan any time in the last 25 years, chances are you’ve had the option to invest in a target-date fund (TDF)—a specialized mutual fund that adjusts its risk level as you approach retirement.
While target-date funds certainly feel like straightforward retirement investments, there are still plenty of ways investors make mistakes. In fact, one study by Financial Engines showed that investors who used target-date funds for less than 90% of their portfolio earned 2.11% lower returns than investors who used their TDFs correctly.
So, what are the most frequent mistakes people make when choosing target-date funds? Below I highlight the four most common mistakes I see with TDFs and a solution for each.
1. Combining TDFs with Other Investments
If you’ve driven a “stick shift,” you know how startlingly simple it is to operate a car with automatic transmission. For many people, it’s almost too simple, and they prefer the nuanced control they get with their five gears and clutch.
In a way, a TDF is the automatic transmission of most 401(k) plans. It takes all the complexity of choosing different stocks and bonds and automates those decisions in one clean wrapper called a target-date fund.
Target-date funds are designed to be the large majority—if not the entirety—of your retirement account. They can do this because, underneath the hood, TDFs actually hold multiple mutual funds. This makes them highly diversified, even as a single investment selection. While it might sound “too simple” to have only a single fund selected in your 401(k), that’s really how they’re designed to be used.
Unfortunately, many people use a TDF as only part of their account, while also investing in other mutual funds. One SEC-sponsored survey showed that 51% of target-date fund owners held less than half of their investable assets in the TDF. Most of the time, investors do this because they mistakenly believe that by owning more funds, their assets are more diversified. But in nearly every case, TDFs are designed with built-in diversification that actually can be counteracted by holding other investments.
If you choose to invest in a target-date fund, you should consider holding at least 90% of your account in that fund.