Question

Target-date mutual funds adopt “glide paths” such that the funds allocate investments across stocks, bonds, and other assets based on the weights that are set in the funds’ set schedules. For example, a 2050 target date fund is likely to be heavily invested in stocks relative to bonds in 2019, but the fund’s investments will gradually shift toward bonds as the year 2050 approaches. What behavior do stock market returns need to display in order for this approach to be optimal? Does the empirical evidence support or refute this required feature of returns?

Answer 1

Target date mutual funds are built such that they have a high risk tolerance when they are started and gradually the risk tolerance reduces. For the approach followed by these funds to be optimal, stock market must show higher volatility in the short term (meaning a higher probability of losing money) than in the long term. And the empirical evidence supports this approach.

Empirically, it is found that stock markets can be highly volatile in the short term. But as the time horizon increases, there is a higher probability of earning a positive return from the market. So, if an amount was invested in the market for the long term, even if the market crashed in the short term, there is sufficient time it to bounce back and still earn a decent return. But as time to maturity comes closer, that probability reduces and risk increases.

This is why, target date funds are highly invested in stocks when there is ample time till the fund matures. But as the fund gets closer to maturity, the risk of being invested in stocks increases and therefore, funds are reallocated more towards bonds.