There’s a general consensus forming among the economics community (both academic and policy) that low-fee target-date index funds are the way that most people should be investing. In fact, they should be the default plan in most people’s 401(k) [default means what you end up with if you don't pick something else]. Obviously people should be able to make their own investment decisions, but for the majority of people who are confused on these topics, a low-fee target-date index fund will best be able to get them where they want to go.
What is an index fund?
An index fund is like a broad based mutual fund that matches a market. Mutual funds are great because they allow smaller investors to diversify their portfolios. With an index fund, instead of paying a mutual fund manager hundreds of thousands or even millions of dollars each year to try to beat the market (which, incidentally, fewer than half of them actually do), a computer tracks the market of the index (often the S&P 500 or Russell 5000, but there are many others) and the index value is based on that. It is a low cost, lower risk, way of matching the market.
Bottom line is: index funds match whatever market they are indexed to at a smaller expense than a standard mutual fund.
Even with an index fund, your returns can be eaten away by fees. Some companies can use their index funds as money makers– they’re not paying money managers anything but they charge much higher fees than they should. This is especially likely when your choices for a 401(K) plan are limited.
If your choices are not limited, look very carefully at your options. If you have several options for index funds that track the same market, go with the company that charges the lowest fees. Vanguard is the lowest cost for index funds and for target-date index funds.
Ignore things like “returns since inception.” All index funds have the same returns for the same index– the only difference in “returns since inception” is whether they started (“inception”) when the market was booming (which shows low returns since inception) or the market was busting (which shows high returns since inception). It’s a meaningless metric.
What is a target date index fund?
A target date index fund is like a mixture of stock and bond index funds that tilts your exposure from stocks to bonds as you get closer to your chosen retirement (target) date. This is great because you don’t have to rebalance your portfolio. You don’t have to recalculate your risk every year. You can just set and forget and your portfolio will be taken care of.
The paradox of choice causes inaction. Figuring out what stocks to choose and what ratio of stocks and bonds can be overwhelming and can cause you to end up not doing anything at all. With a target-date index fund all you have to do is pick one number (and you don’t even have to really be correct!) and set up automatic contributions and the company will take care of the rest. They’ll automatically rebalance as markets change and they will shift your stock exposure into bonds as you need more sure money and less risk in your portfolio.
What date should you choose? Well, take a guess on what year you’re going to retire and pick the date closest to that. If you’re in your 20s now, it won’t matter that much if you get it off by 10 or even 20 years because you’ll still be tilted towards stocks and able to recalibrate for a while. If you’re closer to retirement, then presumably you have a better idea of when you’re going to need to start drawing down those funds.
Another note on fees
If Vanguard (whose target date funds reflect the actual cost of each index they use) is not one of your options, it may be worthwhile to compare the cost of a target-date index fund to matching it with regular index funds yourself. This is especially true if your target date is a long time from now– a target date fund will be heavily invested in stock indexes and you can set and forget for a while before you have to start shifting into bonds. Still, if this idea of having to choose your own portfolio intimidates you, it may be worth paying the additional fee for the Target date fund, even if it is more expensive.
For more information, Boston College has put out this handy primer. This pdf has a lot of great graphs and charts showing how target date funds perform under different scenarios, and this booklet provides more detailed information on the topic.