About the author: The following is a guest article written by Kevin from No Debt Plan. He writes to help readers eliminate debt, learn how to budget and save, and move themselves towards financial freedom.

The first investment we made in one of our Roth IRAs was in a Vanguard Target Retirement fund. Generally target date retirement funds make good investments; if you are just starting to save for retirement it’s a great investment. Flexo recently shared his reservations about these investments, but today I’ll give you four reasons why we like them.

1. It’s an easy start.
2. Low investment needed to start.
3. You get instant diversification.
4. The fund automatically rebalances based on your age.

Let’s look at these individually.

An easy start. You need only one account (Roth IRA, Traditional IRA, taxable investment account, etc.). You invest in one fund. That’s pretty easy to get going and removes a bunch of hurdles.

Low investment needed to start. With any target retirement fund, the only start up cost you have is your minimum investment and then associated expense fees. We opened our Roth IRA with Vanguard because they are known for having low expense fees, and the minimum investments are only $3,000. Once you invest your first $3,000, you can add as little as $100 to your account after that. The kicker is you only need the one fund to get started, which leads us to…

Instant Diversification. The reason you only need one fund starting out, is a target retirement fund gives you a great deal of diversification right off the bat. Let’s take a look at Vanguard’s Target Retirement 2050 Fund (VFIFX) that we are currently invested in:

• 71.61% Vanguard Total Stock Market
• 10.09% Vanguard Total Bond Market
• 9.97% Vanguard European Stock Index
• 4.39% Vanguard Pacific Stock Index
• 3.62% Vanguard Emerging Markets Index
• 0.16% Vanguard Total Stock Market ETF

With one fund, you’re invested in 5 other major investments. Starting out you probably want a large amount of US and International stock exposure. Even if you just wanted these two things you would need two funds to get that diversification. Two funds means two minimum investments. Add additional funds and you add additional minimum investments. Not so with the target retirement fund. One minimum investment and you suddenly have instant diversification.

Automatic Rebalancing. Rebalancing is the act of sitting down once per year and adjusting your portfolio toward your target asset allocation. Let’s say you hold two funds because you want a 50% US stock exposure and 50% International stock exposure. During the last year, it is unlikely the funds have gained and lost exactly the same. So you end the year and US stocks have been up more than International stocks. Your current portfolio weight is 53% US and 47% International.

Doesn’t sound like a big deal, right? Just 3%. Well, over time that gap can get larger and larger until one day you find yourself with a 75/25 allocation—way out of whack.

With a target retirement fund, you don’t have to worry about rebalancing. If 100% of your portfolio was in the fund (not a recommendation, just an example), the fund will rebalance for you every year. As time marches on you will get closer and closer to the target date for the fund. As you get closer, the fund adjusts the portfolio for you to be more conservative.

Let’s compare two of Vanguard’s funds, the Target Retirement 2010 (VTENX) and Target Retirement 2050, to make the point clear. We expect the 2010 fund to have fewer stocks and more bonds/income generating investments than the 2050 portfolio listed above. The 2010 investments include:

• 44.08% Vanguard Total Stock Market Index
• 40.28% Vanguard Total Bond Market Index
• 6.18% Vanguard European Stock Index
• 4.43% Vanguard Inflation-Protected Securities
• 2.69% Vanguard Pacific Stock Index
• 2.27% Vanguard Emerging Markets Stock Index
• 0.05% Vanguard Total Stock Market ETF

The 2010 fund is 55.27% stocks and 44.73% non-stock investments. The 2050 fund is 89.91% stocks and 10.09% bonds. An obviously difference. Over time, the 2050 fund will start to look more and more like the 2010 fund.

What are you waiting for? For all of you new investors out there, I honestly think a Vanguard Target Retirement Fund is one of the best initial investments you could make.

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Target retirement funds are increasing in popularity. The funds, and they may be called “lifecycle funds” or “target date funds” or “age-based funds” or a variety of other terms are mutual funds comprising other mutual funds. The allocation percentages of the constituent mutual funds change as time progresses, theoretically becoming more conservative as you approach your target.

For example, the Vanguard Target Retirement 2050 Fund (VFIFX) is a mutual fund of funds designed for people who expect to retire in the year 2050. You would expect an investment—one that is designed to mirror your investing strategy based on your time horizon—to be quite aggressive in order to make the most of the decades between now and the time you need to access its value.

This reveals the first problem I have with target retirement funds: they are often too conservative. VFIFX contains five other Vanguard mutual funds: Vanguard Total Stock Market Index Fund, Vanguard Total Bond Market Index Fund, Vanguard European Stock Market Index Fund, Vanguard Pacific Stock Index Fund, and Vanguard Emerging Markets Stock Index Fund. As of today, 72% of the fund is invested in the Total Stock Market, 10% is invested in the Total Bond Market, and the remaining 18% is split between the others in amounts hardly meaningful.

I don’t see this as aggressive enough for someone who has such a long time horizon. I would suggest eliminating the bond component entirely and distributing the rest towards the international funds.

My second issue with target retirement funds is how it could lull an investor into a false sense of safety and security. While creating a hands-off approach to investing, it encourages buying and holding which is great for long-term success, but it opens the door to complacency. Your reallocations are on auto-pilot, so if you decide to change your time horizon, you may find yourself under or over-exposed to risk. Also, Vanguard, or which ever management company you choose for your target retirement fund, may decide to change strategies in the future, to the point where their guidelines no longer match your expectations.

Target retirement funds to encompass your entire portfolio. If you’ve chosen the Vanguard Target Retirement 2050 Fund for your entire 401(k) election, but you have a Roth IRA where this fund is not available, then you’re modifying your asset allocation away from that prescribed by Vanguard. If you are comfortable with Vanguard’s exposure to equities in their fund but you decide to invest in VTSMX separately in your Roth IRA, you’ve disturbed your overall asset allocation and opened yourself up to risk you may not have intended for your retirement funds.

Fund managing companies can’t seem to agree on the most appropriate asset allocation for a certain target. I mentioned Vanguard’s current allocation rule for its “2050” fund. Fidelity has a different strategy for those retiring the same year. The Fidelity Freedom 2050 Fund (FFFHX) invests in 68.5% domestic stock funds, 20.9% international stock funds, and 10.5% bond funds. Overall, this is similar to to Vanguard fund of funds, but the specific composition of the international portion provides a strong enough contrast that could have profound effects over 40 years of investment.

The fees for target retirement funds are usually a combination of the fees of the underlying investments. Rarely, a target retirement fund will add a management fee in addition to the feeds already charged by the funds held. Pay attention to these fees, because they will eat into the value of your investment. With a distant target like 2050, the fees eat into your returns even more.

Money Magazine is recommending that those wishing to build their net worth over a long period of time simplify matters by putting all their eggs into seven baskets in the form of mutual funds.

1. Fidelity Spartan 500 Index (FSMKX). This fund’s total expense ratio is a minuscule 0.10%. It tracks the S&P 500 index.

2. Vanguard Total International Stock Index (VGTSX). “Nearly 60% of the world’s stock market value resides in companies outside our borders,” so you’ll want a piece of that action.

3. T. Rowe Price New Horizons (PRNHX). New Horizons is a small company stock fund. There are periods of time in which small company stocks have outperformed the market at large. This isn’t an index fund, though, so expect to pay an expense ratio of 0.79%, still low for managed funds.

4. Vanguard Value Index (VIVAX) . If you pay attention to value funds, your investments will return dividends. Literally. This fund currently offers a dividend yield of 2.94%.

5. Vanguard Total Bond Market Index (VBMFX). Got bonds? I don’t. But if your asset allocation calls for bonds, this fund beat the industry average by 14% over the past 10 years and its expense ratio is 0.20%.

6. Vanguard Inflation-Protected Securities Fund (VIPSX). First of all, official government inflation statistics underestimate the real increase in prices we see every year, partly because those who calculate the statistics assume Americans “trade down” to lower quality products when prices get high. Thus, inflation-protected securities are likely misguided. Money Magazine has nevertheless included them among the other suggestions.

7. Fidelity Cash Reserves (FDRXX). Cash reserves are good for when you spot a buying opportunity in the market and need flexibility and liquidity to jump. A money market fund like this is decent for at least part of your emergency fund. Personally, since I have some of my retirement accounts at Vanguard, I chose Money Magazine’s alternate, VMMXX. This Vanguard fund features an expense ratio of 0.24% compared to Fidelity’s 0.40%.

Probably more important than the specific funds is the overall asset allocation strategy. Investors spend a lot of time talking about investments, analyzing and choosing the best funds that will help us reach our goals, but asset allocation is just as important. If an investor ignores his allocations, her investments might not provide the results.

Photo credit: epicharmus
The Only 7 Investments You Need [Money Magazine]

A researcher at Central Michigan University surveyed 600 finance professors at major universities to determine their investment philosophies, practices, and the differerences between the two. You would think that those involved in higher education, teaching about market analysis, options and futures, and discounted cash flow analysis, would use these techniques when handling their own investments.

Apparently, most don’t.

About two-thirds of the professors, in fact, have the bulk of their assets in index funds, the low-cost baskets that essentially own the entire market. These academics more or less practice the basic lesson of modern portfolio theory: Diversification is the key to holding down your risk and maximizing your returns. That leaves a third who have gone astray, however.

So what about the remaining third? Surely these professors analyze the details of every stock they own and will know before buying the relevant information to determine the company’s chance of increasing its value. Again, this group of professors ignores their own advice as well, preferring to make purchasing decisions on recent performance. That is, they chase the hot stocks, too.

Of the portion of professors who believe in the “efficient market hypothesis,” which says that a stock’s price already takes all information into account, about 25% still believe they can beat the market by timing its fluctuations. They believe that the market cannot be timed—unless by them.

I don’t expect all professors to follow their own advice at all times. After all, they’re training their students to be finance professionals, fund managers, and analysts. In many cases, the professors are not finance professionals, they are professors. They’re not paid for their trading skills, they’re employed for their teaching skills.

What Really Matters When Buying and Selling Stocks? [James Doran and Colbrin Wright]
Don’t try to invest like the pros [Money Magazine]

Trying to beat the market through trading based on impressions of short-term trends has the opposite effect.

There’s a new study assembled by researchers from three university that shows that those who invest in index funds have better investment returns than those who invest in managed funds. In fact, those who invest in no-load index funds have better returns than those who invest in load index funds (which have additional fees).

The investment results are compared with their own funds. Index fund investors beat the stated returns of their funds.

Investors in no-load (that is, no-commission) index funds actually beat the returns of the funds they hold by 0.42 percentage point annually… Those active-fund investors lag the returns of their funds by an average 1.86 percentage points annually.

To explain further, the 5 year average annual return of VFINX, the Vanguard 500 Index matching the S&P 500 Large-Cap Index, is 11.48%. The average index fund investor, according to this research, actually earns 11.90%. The average investor in AIVSX, a large-cap managed fund with a 5 year average annual return of 12.08% with a 5.75% front-end load, actually earns 10.22% annually.

This is attributed to trading behaviors. Index fund investors are less likely to enter and leave the stock market at the wrong time.

The study was sponsored by Zero Alpha Group, an organization that holds the philosophy that the best investment strategy is passive investing. “Zero alpha” refers to the idea that active management of a fund provides no benefit over a benchmark like an index.

Index-Fund Tortoises Are Long-Term Winners [Wall Street Journal]
Press Release from Zero Alpha Group
Investor Timing and Fund Distribution Channels [pdf Report]