There are over 10 million people with a 401(k) or 403(b) who potentially invest in both a target-date fund and other assets, according to a new report from Morningstar, an investment research firm. But doing so could possibly hurt your bottom line.
That's because target-date funds already hold a diverse array of stocks and bonds that rebalance automatically over time. They are designed to simplify the investing process: An investor can select the single fund that aligns with their risk tolerance or expected retirement year, and the work of picking stocks and bonds is done for them.
Selecting other investments in addition to a target-date fund, then, "significantly diminishes" its efficacy, according to the report, which analyzed the allocation decisions of 30,516 investors who mix target-date funds with other types of assets.
"Less efficient portfolios means lower realized returns," David Blanchett, head of retirement research for Morningstar Investment Management and the author of the report, tells CNBC Make It.
Instead, target-date funds are best used as an "all or none investment."
Individuals may combine investments because they don't understand what a target-date fund actually is. While they think adding other stocks or funds will help them "out perform" the market, they are actually diluting the value of a target-date fund.
"They may appear as a single investment option and participants may not realize the target-date fund is in fact a diversified, multi-asset fund intended to be a standalone investment," the report says.
Investors who mix their target-date funds with other investments tend to be more aggressive, the report says. But rather than adding stock funds to their investment mix, they'd be better off selecting a more aggressive target-date fund altogether. If they plan to retire in 2045 and are invested in the target-date fund that corresponds with that year, it'd be better to opt for the 2050 or 2060 fund, which will have a higher risk level.
For more savvy investors, selecting your own mix of stock and bond funds might be the smart move. But if you want a hands-off approach or are still learning the ropes, a single target-date fund is the best option.
You won't be alone: There is now more than $1.7 trillion in assets held in target-date funds, per Morningstar, an almost tenfold increase from December 2007. Around 80% of plan participants invest in a target-date fund when it is offered as the plan's default.
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