Target-Date Funds: The Answer to Bad Investor Behavior?

If you think like a behavioral economist, target-date funds are the partial solution to a perennial problem: Making good choices when it comes to saving for retirement.

That's because bad choices abound. For those of you scoring at home, here's a recap of some of the most popular behavioral errors in saving and investing.

Fear of Regret. We jump into a stock because we fear that if we don't buy it we'll be missing out on something big. This is the major motivator behind initial public offerings. We will miss the next  Google (GOOG),  Facebook (FB), or  Microsoft (MSFT). What most brokers don't tell you is that most young businesses fail in five years or don't make money. Brokers and insiders, however, do very well on these deals.

Fear of Loss. Let's say you bought the "next Google," but it turns out to be a dog with a share price that just keeps going south. How hard is it to dump the stock at a loss? On an emotional level, losses are felt twice as intensely as gains, so we hold on, hoping for a bounce back. But the rational thing to do is to get rid of the stock and take a tax loss. This also applies to getting in and out of the market, particularly during downturns when share prices are cheaper.

Overconfidence. We are absolutely sure our company's stock or latest hot tech issue is far better than owning an unsexy, broad-based index mutual fund, so we dive into the unknown. It's hard to say how many get burned by this gut feeling; I would suspect millions. Just falling for the "narrative" of a company--it's a good story--entraps far too many investors.

Framing & Anchoring. We pick arbitrary price or index levels to get into a security or stock market. We feel that "now the time is right" or "that price is reasonable." A lot of this reasoning is irrational because it's based on emotion. It keeps us glued to a stock that should have been sold or one that was bought at the top of the market.

Enter target-date funds, vehicles that run on autopilot until a specific date--presumably when we retire. Every year, they ratchet down stock market risk and ramp up exposure to bonds and cash. Their glide paths do everything gradually as we get older. There's no darting in and out of the market and no timing decisions to be made. A mutual fund company does all the work, usually within a retirement account, such as a 401(k). There's a reason why this one product has created a $600 billion subindustry.

Not having to make a decision can make a huge difference in your total return over time. Morningstar looked at investor returns--what people actually made when they had control over their money--compared with the S&P 500 index for the decade ended Sept. 30, 2013. Those left to their own devices in the median U.S. large-stock blend fund earned a 6.2% return during the decade.

What happened if you just left your money alone during that period? You reaped a 7.5% return just leaving your money in an S&P index fund. A full percentage point is a huge deal over time.

Ideally, because target-date funds take most of the decision-making out of your hands, they can work well in thwarting some of your worst instincts. If you're decades away from retirement, you are mostly buying stocks--in bull and bear markets. If you're near retirement, you are much less exposed to stocks, so you don't have to guess when to pull out. Sounds like a savvy solution, no?

Chinks in the Target-Date Fund Armor
Because you relinquish control in a target-date fund, you obtain a certain degree of confidence over your retirement savings. After all, professional managers are figuring out the right stock/bond mix for your age and want to protect your nest egg.

The loss of decision-making can backfire, however. What if the U.S. economy heads into a hyper- or stagflationary period as it did in the 1970s and early 1980s? Then most bonds (except for inflation-adjusted bonds) and many stocks become terrible investments.

What if stocks fell into a nosedive just before you retired? Most target-date allocations are based on assumptions that stocks usually outperform bonds and that fixed-income vehicles are lower-risk than equities. Yet you will still have inflation risk, which most bonds are vulnerable to: They lose value when interest rates or inflation rises.

In that view, the conventional wisdom may be wrong and could lead to another bias because the glide path you've chosen may become an emotional anchor.

Consider this: Won't you need income when you're not working? If bond yields remain low or inflation perks up, you could be in trouble with a Treasury-heavy glide path in your seventh decade and beyond. Even with additional risk, stocks typically produce a higher total return than bonds over time. And if you live into your 10th decade, bonds will not keep up with inflation, medical expenses, or other costs of living.

When Rob Arnott, chairman of Research Associates, ran the numbers, he found out that a better performance could be obtained by an inverse glide path that starts out with a relatively low percentage in stocks and ramps up to around 80% in stocks by age 65. He discovered that this allocation results in a 10-year increase in real income of 236%, compared with a 154% gain for the conventional glide path that starts with 80% stocks and ratchets down to 20% by age 65.

What happened to that stomach-turning aversion to risk as we get older? In Arnott's model, you offset one of the worst risks--loss of purchasing power--by adding vehicles that usually run in lockstep with inflation: Commodities, bank loans, Treasury Inflation-Protected Securities, high-yield bonds, and convertibles. (Does your current target-date fund contain these vehicles?)

See the behavioral disconnect that may be lurking in your target-date fund? There may be an underestimation of the biggest risk you face--outliving your money. You also may suffer from a lack of flexibility.

What if you change your mind and decide to retire much later than your "target date?" What if you want more growth (read: stocks) in your portfolio to offset longevity risk, or the prospect you may live 40 years past your retirement year? What if you retire and want to go back to work? Most target-date funds are locked into their glide paths and allow for almost no customization. If you want flexibility, they may not be the right vehicles for you.

But if you opt out of a target-date fund, don't you face the same old demon of behavioral issues? Won't you go back to mistiming the market? Not if you prepare and execute an investment policy statement that spells out how much risk you want to take (that is, how much you can afford to lose) and how you want to invest. Adjust and rebalance this plan once a year.

It's OK if you don't want to go it alone. You may avoid behavioral errors if you work with an advisor who keeps you on track. Just make sure you customize the plan to your lifestyle, career, family goals, and ability to handle risk. The best kind of behavior in this realm is thought out carefully and slowly over time. 

Arnott data from presentation delivered to the Metropolitan Club in Chicago, June 19, 2014.

John F. Wasik is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.