Retire Richer? The Vanguard Guide to Target Retirement Funds
What is Investment?
It’s All About Time.
Investment is all about managing time. The contents of your portfolio, and their risk levels, should be carefully considered in your investment timeframe.
A young person in their 20s has years ahead, while an older investor has a shorter horizon. So, how should age influence investment decisions? Does your birth year (or time left until retirement) dictate how many stocks or government bonds you hold?
“Stocks offer higher returns than bonds, so why not just buy stocks regardless of age?” you might ask.
In the world of finance, both return and risk are crucial factors. High returns often come with greater risk, and vice versa.
For example, stocks (on average) generate higher returns than government bonds but are also riskier. Conversely, government bonds deliver lower returns (on average) but carry less risk.
Someone investing in a stock index might experience high average returns, but also face sharp downfalls during certain years. In contrast, a government bond investor might earn less, but enjoy greater peace of mind and smoother price movements.
So, how does someone’s age, which translates to time until retirement, relate to their portfolio?
While stocks are riskier, a young investor with the luxury of time can benefit from their long-term potential. Over time, market downturns often give way to upturns. (The key word here is may, not will, as nothing is guaranteed in finance.) Therefore, young individuals with 40-50 years until retirement can typically maintain a higher stock allocation to weather occasional dips.
However, the situation changes for older investors nearing retirement. They should prioritize assets with lower risk, such as bonds or cash, as they have fewer years to recover from potential stock market crashes.
READ HERE> Dividends: Your Guide to Retiring on Passive Income
Do Financial Theories Support Age-Based Portfolios?
Interestingly, the answer was no until recently. Traditionally, finance theory didn’t recognize a link between investor age and their optimal portfolio. However, a 2009 study challenged this notion, demonstrating that – theoretically – younger investors should hold more stocks while older investors should favor bonds.
Finding the Right Mix: Vanguard Target Retirement Funds
Determining the ideal asset allocation based on age can be challenging. Fortunately, leading fund companies like Vanguard offer solutions – their Target Retirement Funds. These funds, categorized by your birth year and remaining time until retirement, allocate varying percentages to US and world stocks, government bonds, and inflation-protected cash.
The funds here are funds that invest in what we call Funds of Funds. For example, let’s take the first fund, its name is VSVNX, and it is recommended for those born between 2004 and 2008. Now look at the other photo, it shows where and how much money this fund invested.
As you can see, extremely high stocks are recommended for people who are 50 years away from retirement. For example, this fund invests 54% in US stocks. But is it making this investment itself? Mostly no. These funds invest in other funds. Since each fund has different operating fees and management methods, even if they are doing the right thing in concept, they may be choosing the wrong fund.
You will be able to see the operating fee and all other details by typing the name and code of a fund at this address:
https://tools.finra.org/fund_analyzer
Vanguard’s Recommendations:
For age groups, Vanguard suggests the following asset allocations:
- 50 years left:54% US Stocks, 36% World Stocks, 7% US Government Bonds, 3% World Bonds
- 20 years left:48.20% US Stocks, 30.80% World Stocks, 14.90% US Government Bonds, 6.10% World Bonds
- 5 years left:33.10% US Stocks, 22.50% World Stocks, 27.80% US Government Bonds, 12.10% World Bonds, 4.50% Inflation-Protected Cash
- Retired:18.20% US Stocks, 12.40% World Stocks, 36.50% US Government Bonds, 16.20% World Bonds, 16.70% Cash
Beyond Vanguard:
While Vanguard provides valuable insights, precise figures are hard to come by in this field. Other reputable fund companies like Morgan Stanley also offer age-based portfolio recommendations. Ultimately, the optimal allocation depends on your circ*mstances and risk tolerance.
Conclusion:
- Younger investors should generally favor stocks (indexes, not individual stocks) while older investors should lean towards bonds and inflation-protected cash.
- Exact asset allocation percentages vary, but organizations like Vanguard and Morgan Stanley offer guidance based on time until retirement.
- While finance theory previously disregarded age, recent research suggests younger investors may benefit from higher stock allocations.
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* This study was published in the Journal of Monetary Economics. Journal of Monetary Economics is one of the most important academic journals in its field.
For those interested, the academic link to the article:
https://www.sciencedirect.com/science/article/abs/pii/S0304393209001007
