Many investors approach the financial markets like they do the weather. They listen to forecasts and react, trying to predict changing prices as if they’re changing temperatures or the chance of precipitation. Investors’ actions are often driven by fear. They don’t want to risk getting caught in the rain without an umbrella or being left out in the cold.
The problem is that investors are human, so emotions can influence their decisions. When markets are stormy, investors sometimes flee to perceived safety—selling stocks and buying bonds. But, taking an emotional, reactive approach to volatility can hurt an investor’s odds of being ready when it’s time to retire.
One reason many plan sponsors select target-date funds (TDFs) as their plan’s qualified default investment alternative (QDIA) is to curb emotional investing. TDFs are structured to help remove the emotion from investment decisions.
“TDFs are a diversified, all-in-one solution, designed to weather economic climates within the context of an investor’s age,” explains John Croke, Vanguard’s head of multi-asset product management. “Younger investors, theoretically, can withstand more volatility because a larger percentage of their total wealth is in human capital versus their financial holdings. As investors age, the TDF glide path mitigates volatility by moving gradually into a broadly diversified mix of more conservative assets.”
By year-end 2016, nearly all Vanguard participants were in plans offering TDFs. Three-quarters of participants whose plans offered TDFs had an investment in them.¹ And, it is projected that 90% of new contributions will go into TDFs by 2020.²
“While long-dated TDFs will experience significant declines during large equity market corrections, Mr. Croke continued, “TDF glide path design helps ensure that the risk is being taken at a time when the investor has time to be compensated for it.”
How Vanguard Target Retirement Funds weather storms
“Periods of volatility provide an opportunity for us to showcase how Vanguard Target Retirement Funds can work for investors, even when conditions are unsettling,” says Scott Donaldson, senior investment analyst, Vanguard Investment Strategy Group. “Our professionally managed indexed Target Retirement Fund solution is continuously rebalanced to track its benchmark. The rebalancing naturally leads to selling bonds, which tend to go up in value when there is market turmoil. On the other hand, Vanguard Target Retirement Fund equities are generally purchased as they become undervalued. By virtue of rebalancing to its long-term target allocation, the Target Retirement Fund can benefit from an old-fashioned buy-low, sell-high approach.”
Left to their human nature, investors unfortunately tend to do the opposite. “Investors need to remember that volatility isn’t necessarily bad,” Mr. Donaldson explains. “It depends on an investor’s objectives and if he or she is being ‘paid’ for the volatility.”
“If you look at the global financial crisis in 2008 and 2009, you saw some very good things happening from a participant behavior standpoint,” Mr. Croke continues. “Most individuals stayed fully invested in their target-date funds. And while clearly there were some unnerving moments and capital losses that occurred on the way down, by remaining fully invested, investors in target-date funds were able to capture the seven-plus-year bull market in equities that we’ve experienced since the depths of the crisis.”
Source: Vanguard, Flight to safety? Market volatility and target-date funds, March 2009.
Annualized equity abandonment rates is the average rate per year that investors move assets out of equities.
Mixed target-date investors combine a target-date fund with other plan investment options.
Simply sophisticated—and low-cost
Constructed from four underlying index funds—five, in the case of near-dated funds—Vanguard Target Retirement Funds combat volatility by diversifying globally in equity and investment-grade-only bond markets. While other TDFs may include more funds, Vanguard Target Retirement Funds include about 26,000 securities. Our Target Retirement Funds are not exposed to high-yield bonds, which sometimes behave more like equities during times of volatility. We also avoid trendy alternative asset classes, which may water down the diversification benefits that can be provided by a higher-quality investment-grade-only fixed income portfolio without offering material advantages.
Vanguard’s attention to keeping costs low also benefits a participant’s bottom line. Since launching Target Retirement Funds in 2003, Vanguard has lowered Target Retirement Fund costs by 30%. We accomplished this even as we gradually expanded into non-U.S. equity and fixed income markets, which are more expensive to own.
For rain or shine
We are never without weather. And, we are never without potentially unsettling conditions that may spark market volatility. Elections and referendums, terror attacks, natural disasters, monetary policy developments, and regulatory changes are but a few of the contributors to market ups and downs.
TDFs can help your participants avoid emotional reactions to such events—reactions that could disrupt their plans for retirement. By choosing and sticking with TDFs, investors can mitigate the effect of volatility over time. TDFs can be sound investments, come rain or shine.
²Cerulli and Associates, 2015.
- All investing is subject to risk, including the possible loss of the money you invest. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
- Diversification does not ensure a profit or protect against a loss.
- Investments in bonds are subject to interest rate, credit, and inflation risk.
- Past performance is no guarantee of future results.
- Investments in Target Retirement Funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in the Target Retirement Fund is not guaranteed at any time, including on or after the target date.