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I just calculated out that investing my Roth IRA in a Lifecycle fund will cost me about $65k more than investing directly in the underlying funds, effectively doubling the expense ratio. And the funds they choose aren't exactly low expense either!

I'm considering implementing my own retirement investing strategy based on this approach, but one of many questions I have is: do I really need all these funds? There's like 9 funds the fund allocates less than 2 percent to, and I expect the glide path to shrink those over time. I understand there's some benefits to diversification, but I don't see how allocating 1 percent to "small cap growth" can offset losses from an "all sector" investment ten times its size.

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    I've tried to avoid endorsing a specific fund here, so I hope the lack of specifics doesn't make this impossible to answer! – jldugger Aug 22 '11 at 15:04
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    I think this question is still answerable without a specific fund. In fact, I think it makes a better question. – Alex B Aug 22 '11 at 16:03
  • FWIW, I reviewed the prospectus of my fund, and I misspoke. It charges no management fees; the reported expense is 'acquired'. Still, it's about double what my 403b charges for a similar lifecycle fund, and I imagine I could cut that lower fee in half by self-balancing... – jldugger Aug 29 '11 at 2:19
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If you read Joel Greenblatt's The Little Book That Beats the Market, he says:

Owning two stocks eliminates 46% of the non market risk of owning just one stock. This risk is reduced by 72% with 4 stocks, by 81% with 8 stocks, by 93% with 16 stocks, by 96% with 32 stocks, and by 99% with 500 stocks.

Conclusion:

After purchasing 6-8 stocks, benefits of adding stocks to decrease risk are small. Overall market risk won't be eliminated merely by adding more stocks.

And that's just specific stocks. So you're very right that allocating a 1% share to a specific type of fund is not going to offset your other funds by much.

You are correct that you can emulate the lifecycle fund by simply buying all the underlying funds, but there are two caveats:

  1. Generally, these funds are supposed to be cheaper than buying the separate funds individually. Check over your math and make sure everything is in order. Call the fund manager and tell him about your findings and see what they have to say.

  2. If you are going to emulate the lifecycle fund, be sure to stay on top of rebalancing. One advantage of buying the actual fund is that the portfolio distributions are managed for you, so if you're going to buy separate ETFs, make sure you're rebalancing.

As for whether you need all those funds, my answer is a definite no. Consider Mark Cuban's blog post Wall Street's new lie to Main Street - Asset Allocation. Although there are some highly questionable points in the article, one portion is indisputably clear:

Let me translate this all for you. “I want you to invest 5pct in cash and the rest in 10 different funds about which you know absolutely nothing. I want you to make this investment knowing that even if there were 128 hours in a day and you had a year long vacation, you could not possibly begin to understand all of these products. In fact, I don’t understand them either, but because I know it sounds good and everyone is making the same kind of recommendations, we all can pretend we are smart and going to make a lot of money. Until we don’t"

Standard theory says that you want to invest in low-cost funds (like those provided by Vanguard), and you want to have enough variety to protect against risk. Although I can't give a specific allocation recommendation because I don't know your personal circumstances, you should ideally have some in US Equities, US Fixed Income, International Equities, Commodities, of varying sizes to have adequate diversification "as defined by theory." You can either do your own research to establish a distribution, or speak to an investment advisor to get help on what your target allocation should be.

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    They're not cheaper. Do the math. The fund invests in other funds, each with their own internal expense ratio, and then charges another expense ratio on top of that! How could it be cheaper?! – jldugger Aug 22 '11 at 16:15
  • +1 for Joel quote. I'd only comment that the stocks need to be properly chosen, hopefully it's obvious that 10 stocks in the same sector provide far less diversification that 5 chosen from different sectors. Also agree that a Vanguard "total market" type ETF is enough to cover US stocks, the lists of funds I've seen in target date products boarder on the absurd. – JoeTaxpayer Aug 22 '11 at 17:09
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    @jldugger - A fund of fund could be cheaper if they have special connections with the underlying funds that cause them to discount the expense ratio. Otherwise, I agree that a fund of fund will never be cheaper than buying the underlying funds separately, but you have to consider that you're paying the fund of fund to rebalance and manage the internal funds as well. – BlackJack Aug 22 '11 at 19:06
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The goal of the single-fund with a retirement date is that they do the rebalancing for you. They have some set of magic ratios (specific to each fund) that go something like this:

Years to Retirement | Asset Mix
       40           | 90% stocks, 10% bonds
       30           | 80% stocks, 20% bonds
       20           | 70% stocks, 30% bonds
       10           | 50% stocks, 50% bonds
        0           | 30% stocks, 70% bonds

Note: I completely made up those numbers and asset mix.

When you invest in the "Mutual-Fund Super Account 2025 fund" you get the benefit that in 2015 (10 years until retirement) they automatically change your asset mix and when you hit 2025, they do it again. You can replace the functionality by being on top of your rebalancing.

That being said, I don't think you need to exactly match the fund choices they provide, just research asset allocation strategies and remember to adjust them as you get closer to retirement.

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Over time, fees are a killer. The $65k is a lot of money, of course, but I'd like to know the fees involved. Are you doubling from 1 to 2%? if so, I'd rethink this. Diversification adds value, I agree, but 2%/yr? A very low cost S&P fund will be about .10%, others may go a bit higher. There's little magic in creating the target allocation, no two companies are going to be exactly the same, just in the general ballpark. I'd encourage you to get an idea of what makes sense, and go DIY. I agree 2% slices of some sectors don't add much, don't get carried away with this.

  • It's vitally important to note that diversification of stocks isn't enough (it leaves "market risk" to borrow from the Joel quote elsewhere). There's bonds, real estate, cash, commodities, etc. So diversification between asset types matters just as much as between sectors. That said, I invest my 401k in a very low S&P fund. We just got access to the Investor grade funds last year, which cut expenses down a lot! – jldugger Aug 22 '11 at 18:20
  • @jldugger, agreed, I didn't mean to imply otherwise. Nor do I claim any expertise in creating the right allocation. At a high level, I know that I'd like to be about 60/40 stock/bond at retirement and am too heavy in stock right now. – JoeTaxpayer Aug 22 '11 at 22:26

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