Lifestyle fundWhat it is: Also called asset allocation funds, these are mutual funds with an asset allocation mix that fits a risk-and-return profile chosen by the investor. Asset allocations are based on whether the fund has a conservative, moderate, balanced or aggressive investing approach.
Pros: These funds usually offer broad diversification in one fund, much like a target-date fund. People can supplement with another fund if they want more exposure to small-cap equities or foreign stocks.
Cons: Investors must make their own asset allocation adjustments. Unlike target-date funds, consumers cannot count on the fund to grow gradually more conservative over time.
Luckily, people don't have to make changes frequently. "It's maybe a dialing down of 70 percent of equities you had 10 or 15 years ago, and then as you approach retirement you might scale that back to 50 percent, and as you go through retirement, you might continue to scale that back," says John Nofsinger, a finance professor at Washington State University. He advises always keeping a significant portion in equities because of inflation and longer life expectancy.
Index fundWhat it is: A type of mutual fund that follows a particular market index, such as the Standard & Poor's 500 index.
Pros: Index funds are typically well-diversified and cheap, because investors are not paying for the stock-picking prowess of a fund manager. "If you keep your costs down, you're going to beat the majority of actively managed funds. That's the virtue in it," says Tyson.
Cons: Without active management to move money into the sectors that may outperform others, investors may be disappointed that index funds passively follow the market, both up and down. "An index fund isn't likely to just blow away its actively managed rivals in a particular year," says Greg Carlson, a fund analyst at Morningstar. "On the flip side, it's not going to lag behind the typical actively managed fund, either."
Another con is that index funds don't offer one-stop shopping like target-date funds and lifestyle funds. "I don't think an S&P 500 is a stand-alone holding," says Carlson. "I think you want exposure to other types of stocks, small-cap and foreign."
Not all index funds are inherently diversified. "I would just say if you're going to index, make sure you choose a broad enough index and certainly don't do things like buy an index fund for a specific industry group -- that kind of defeats the purpose," says Tyson.
Tips for getting startedIf you're considering a target-date or lifestyle fund, make sure the investment approach of the firm managing your fund matches your risk tolerance and expectations for returns. Funds with similar names can have asset allocation mixes that significantly vary from one company to another.
Also consider how fees will eat into your returns. "In the long run, once you make the asset allocation decision, the fees can be a significant determinant of your long-term returns," says Tyson. He recommends looking at Vanguard as a benchmark for fees.