This is an important enough concept to spend a bit more time explaining.

Recall the Target Date Fund in your 401k, in theory, is to protect your retirement savings account by rebalancing your portfolio every year by moving money out of equities and into the bond market (bond funds, actually) in greater proportion as you get closer to retirement age.

Let’s assume, simply for the sake of discussion, that, based on your age and desired retirement date the Target Date Fund for you begins with a mix of 70% equity funds and 30% bond funds. On the first annual date specified for the Target Date Fund to rebalance the new mix will be 65% equity funds and 35% bond funds.

photo © 2008 Tim Green | more info (via: Wylio)
On the date the Target Date Fund is to be rebalanced, does it matter if the equity funds represent 80% because it was an exceptional year for equities and the bond fund value fell? No. We will sell enough of the equity funds to get the mix to 65/35.

Suppose the equity funds fell to 60% of the Target Date Fund at the end the year because it was not a good year for the equity markets and perhaps a good year for the value of the bond fund? Would that matter? No. In this case, we will sell enough of the bond fund to add to the equity fund to bring the mix to 65/35.

And, oh by the way, we will do this again every year.

“Wait a minute!” you say. “I don’t want to fire the manager who made me money and give it to the manager who did not do as well or lost me money!”

Get the idea? Does this make any sense? If I came to you in your business and said “I see that you have 80% of your revenue coming from 20% of your customers. We need to rebalance that. Let’s tell some of them to go away and devote our time, talent and money to try to get the worst customers to buy more from us.” If I said that to you I have no doubt you would get me out of your office as fast as possible. And you should!

This idea of rebalancing is not confined to the Target Date Funds in your 401k options. More likely than not, it is the driving idea at the core of your 401k plan: Modern Portfolio Theory and asset allocation