Do You Have the Right Mix of Stocks and Bonds?

These funds have become especially popular in 401(k)s and similar retirement plans, because they're ideal for investors who don't have the desire or expertise to make long-term allocation decisions themselves. So many of them have sprung up in the past five years that last year we created three new fund categories for them--target-date 2000-2014, target-date 2015-2029, and target-date 2030+. This article by Greg Carlson and this one by Chris Davis give a good overview of what's out there.

Even if you don't own any target-date funds, they can still be a helpful source of ideas for managing your portfolio. Fund companies put a lot of effort and research into deciding these funds' asset allocations and how those allocations will change over time. By looking at the range of target-date funds appropriate for your time horizon, you can get an idea of whether your own portfolio is aggressive, conservative, or somewhere in the middle.

What's the Right Stock/Bond Mix?
To start, let's consider one of the most basic asset-allocation questions: How much of your portfolio should you hold in stocks, as opposed to bonds or cash? In general, the longer your time horizon (that is, the further you are from having to spend the money you've saved), the more you can safely keep in stocks. That rule of thumb is reflected in target-date funds, but funds from different families can vary, sometimes significantly, as to what percentage is appropriate.

As an illustration of both of these points, consider the following table. It shows the average equity (stock) percentage in all the funds in our database with five different target dates, ranging from 2005, for people who are already newly retired, to 2045, for people in their mid-to-late 20s. The table also shows the highest and lowest equity weightings in each group, to give some idea of the range that's available. (To see the table, click here:

The average equity percentage rises steadily as the target dates get farther off, reflecting the fact that those with longer time horizons need to focus more on capital appreciation than on preserving their principal. However, there's a wide range within each group, reflecting the lack of a broad consensus over the best stock allocation for a given age. For example, AllianceBernstein's 2035 (NASDAQ: - ) and 2045 (NASDAQ: - ) target-date funds have 97% of their portfolios in stocks and nothing in bonds, whereas Wells Fargo's 2035 (NASDAQ: - ) and 2045 (NASDAQ: - ) funds have 60% in stocks and 32% in bonds. These represent the aggressive and cautious ends of the asset-allocation spectrum. From these numbers, investors in their 20s and 30s can glean that they should have upward of 80% of their assets in stocks and stock funds, and even those already in retirement should consider devoting a healthy portion of their portfolio to equities.

How Much Should You Invest Overseas?
Another asset-allocation question that every investor has to face is the amount of foreign exposure to have. Chris Davis explored this very topic in a recent The Short Answer column. But how do target-date funds tackle this question? The following table shows the average percentage of the overall portfolio devoted to foreign stocks in each target-date group and shows the range within each group. (To see the table, click here:
http://news.morningstar.com/articlenet/article.aspx?id=212809

Here, as with the first table, the average foreign exposure gets progressively higher as the target dates get farther off. However, this is mainly due to the fact that the later groups hold more stocks. As a percentage of overall equity weighting, the foreign weighting here is remarkably consistent, between 25% and 30% in each group. The ranges in these groups are also less dramatic than in the first table. What this suggests is that there is a consensus among target-date funds that around 25% of the stocks in your retirement portfolio should be foreign. The fact that this percentage stays fairly static, even for investors with short time horizons, reflects the now widely held view that foreign stocks aren't inherently more risky than domestic ones. If your overseas exposure is much lower or much higher than this, it might be a good idea to rethink your allocation.

What's the Proper Large/Small Split?
Other portfolio characteristics, such as the amount of large-cap stocks (as opposed to small- and mid-caps), show a similar pattern. This table shows how much of the average fund's stock weighting is in large caps for each of the target-date groups we've been looking at. (Note that these are percentages of just the fund's stock holdings and not of the portfolio as a whole.) (To see the table, click here:
http://news.morningstar.com/articlenet/article.aspx?id=212809

In theory, someone with a longer time horizon should be able to hold more small- and mid-cap stocks, which are riskier than large caps but generate somewhat higher returns over time. In practice, target-date funds don't seem to differentiate a whole lot. The 2005 target-date funds do have the highest weighting in large caps, slightly, but after that the percentages are very similar, bouncing around 70%. The ranges are also very similar across the various time horizons, but they're very wide.

Compare and Contrast
So what does all this mean for you? If you want to see how your own portfolio compares with an appropriate group of target-date funds, as we've just done above, the first step is to find out what's in your portfolio. If you're a Premium Member of Morningstar.com and have stored your portfolio on the site, the easiest way to do that is through Portfolio X-Ray, which you can reach by clicking the X-Ray tab from within Portfolio Manager. If you're not a Premium Member, you can still do an X-Ray by entering your holdings in the free Instant X-Ray tool. When you use either of these tools, look at the upper left corner of the page under Asset Allocation. Here is where you can see what percentage of the portfolio is in cash, U.S. stocks, foreign stocks, bonds, and other. Over to the right, under Stock Style Diversification, you'll see how much of your stock portfolio falls into each of the nine areas of the Morningstar Style Box.

If you're not sure which target-date funds make for the best comparison, just add 65 to the year of your birth and round off to the nearest multiple of five. Thus, if you were born in 1950, give or take a couple of years, a target-date 2015 fund would be appropriate. If you were born around 1965, you'll want to look at target-date 2030 funds. (Almost all target-date funds go in five-year intervals.)

Once you know what you're looking for, you can start by comparing your allocation to those of an appropriate group of target-date funds from the tables above. This is mainly a gut-check to make sure your weightings are in the right ballpark. If they're not--if, say, you're 60 years old and have 90% of your portfolio in stocks, with 50% of those foreign--it's worth taking a step back to figure out whether you really want that allocation.

For a more thorough comparison, you can look at individual target-date funds. Premium Members can look at the Fund Analyst Picks for our three target-date categories, or anybody can use the free Mutual Fund Screener to find funds in those categories for comparison. From any fund's Snapshot page on Morningstar.com, click on the Portfolio tab on the left to see its asset allocation and other portfolio information.

David Kathman, CFA does not own shares in any of the securities mentioned above.