The Italian economist Vilfredo Pareto is famous for creating what is now known as the Pareto Principle, or the 80-20 rule. Pareto discovered that 80 percent of the land and wealth in his country was owned by 20 percent of the population. Subsequent research showed similar land and wealth distributions in other countries and proved the concept could be applied to other topics. The Pareto principle is a popular concept in management and economics, and can even be applied to personal finance. Applying the Pareto Principle to our financial planning can help the approximately 80 percent of the population who are beginning to intermediate investors and don’t have the time or desire to devote to managing an investment portfolio full-time to gain the most results with the least amount of effort.
Get the biggest bang for your investment buck through target-date funds. Target-date funds, or life-cycle funds, are designed to replicate an entire portfolio through one investment. These funds are actually a combination of several funds which are weighted within the fund based on your estimated retirement date. Those who are retiring in 40 years generally have a heavier allocation of stocks than someone who is retiring in 20 years. The allocation of stocks and bonds is automatically adjusted each year, shifting more of the balance away from stocks and toward fixed income securities as you get nearer to your retirement date. The result is a relatively low-cost fund which is diversified, easy to manage, and has an appropriate risk level.
The benefits of target-date funds. Target-date funds are a one-size-fits-all investment, which is great for people who don’t have the knowledge, time, or desire to manage an active portfolio. Target-date funds are essentially an entire investment portfolio in a single investment. Since the allocation automatically adjusts, they don't require much maintenance or monitoring, making these investments ideal for the beginning investor.
Target-date investments will almost always be diversified. And since they automatically adjust their allocation to reflect your desired retirement date, they should have an appropriate risk level based on your age. Target-date funds are commonly offered as a 401(k) investment option, and you can also find them at most major brokerage houses and online brokerages, making them easy to incorporate into your retirement plan.
The drawbacks of target-date funds. What is a benefit for new investors can be a detriment to a hands-on investor. Some investors may feel limited by the structure of target-date funds, since they are a one-size-fits-all investment. Target-date funds also don't always mesh very well with other investments, since a target-date fund is designed to act as a self-contained investment portfolio. You can use a target-date fund with other investments, but you will need to pay extra attention to your overall asset allocation to ensure your investments are set at the appropriate risk level for your age and risk tolerance.
Also, watch out for fees. Many target-date funds are created by lumping together several index funds with low expense ratios. Target-date funds that have relatively low expenses can be worth adding to your portfolio. However, some target-date funds use actively managed funds or more expensive mutual funds and come with a higher expense ratio than you should pay. Research the fund's expense ratios and the types of investments it contains before investing.
Consider target-date funds the 80-20 solution to investing. Target-date funds can be a quick and easy way to begin investing. These automated funds can help you make sure your portfolio is diversified in an age-appropriate way with little action required on your part.