In this retirement series, last week we talked about where to set up our retirement accounts. Today, we’re going to talk about how to choose investments. Of course, I can’t tell you which investments you should choose to help you meet your goal, but I hope this gets you started.
Note that we’re not researching individual stocks. That’s far too complicated, and for many it’s too risky. Instead, we’re interested in mutual funds (a collection of stocks and bonds from a variety of companies, selected by a fund manager) and index funds (the entire market, in its category).
Your 401(k) probably has a dozen investment choices. When I log on to my husband’s 401(k) managed at Fidelity, I click on “investment choices and research” to see what’s available to him: 3 large cap funds; 2 mid-cap; 1 small cap; 2 international; 11 target date funds; 2 bond investments; and 1 cash fund.
What in the world do any of those options mean?!
Large Cap(ital) – Funds made with companies with a market value of roughly $10B+. Big, reasonably stable, established companies.
Mid Cap – Funds made with companies with a market value of $2-10B.
Small Cap – Companies with a market value of around $300M-2B. Smaller, possible up-and-coming companies. These are considered riskier than large cap, because there’s more volatility with companies in this mix. These have potential for huge gains, or huge losses. Generally speaking, small cap funds are a great addition to your investment portfolio, but in small quantities. We’ll talk more about how much of each fund we should consider owning next week.
Bonds – Investors are loaning money to the government or companies (depending on the type of bond). Considered a fairly stable investment, but with smaller gain potential than other options. (More: How to define a bond as a financial tool @Dummies)
Growth funds – Funds with stocks expected to grow faster. You’ll probably see “large cap growth” or “small cap value” or any combination of those options to further define the fund.
Value funds – Slower, steadier growing stocks (generally) and often pay dividends.
Blend – A blend of growth and value
Related: Defining large, mid and small caps @ Novel Investor
Why index funds are a great option
Index funds are a collection of many stocks — all the stocks within its category. If you’re looking at a “large cap index” fund, then it’s a fund containing all the large cap funds. If you buy an S&P 500 index fund, you’d be buying a portion of all 500 stocks in that index, for example.
Related: 79% of fund managers didn’t beat the market @CNN Money
Did you catch that? 79%! That’s huge. Maybe you’re among the lucky minority who beat the market, but it’s difficult for full-time professionals to do, and it’s certainly difficult to consistently beat the market. Hefty expense ratios for some of those mutual funds played a part. Index funds typically have really low expenses, because there’s nothing really for a fund manager to manage. Here’s more:
important critical to know a fund’s expense ratio, and if there are any additional fees associated with your investment account (such as front-end or back-end loads, which won’t be included in the expense ratio). The expense ratio is just what it sounds like — fees and expenses associated with that fund. A high expense ratio will eat into your profits. This is a BIG DEAL so don’t overlook this step.
Use this calculator to see the impact of going with a fund with a low expense ratio (say, around .2%) vs. a high expense ratio (2%). To illustrate my point, let’s say you have $100k in your retirement accounts right now. Assuming an 8% annual return, 3% inflation, and investing for 33 more years:
- Your account balance if you used a fund with a .2% expense ratio: $3,190,682
- Your account balance if you used a fund with a 2% expense ratio: $2,077,765
- The expensive fund would cost you $1.1M. Ridiculous and unnecessary!
Let’s say you’re comparing the impact of a fund with a .2% ratio with one with a 1% ratio: The same inputs as above would have you come out $562k ahead with the lower-fee fund!
At the start of retirement when you potentially have $1-2M+ in your portfolio, a high expense ratio can cost you more than a million dollars over your lifetime. Why pay a million dollars in unnecessary fees? That’s bananas!
I’d say an expense ratio over .75 – 1% is starting to get up there. It could mean the difference between a comfortable retirement and having to work longer, or part-time.
Related: How expense ratios impact your investment performance @Moolanomy
Compare like funds with like funds. So, if you’re seeking a good large cap value fund, compare that with other large cap value funds. Look at the expense ratios for both to see how they stack up.
Target Date Funds or Life Cycle Funds
If you’d prefer to take a hands-off approach to choosing your investments, consider a target date fund a.k.a life cycle fund. You choose a fund based on your projected retirement year. For example, my fund at Vanguard is called “Vanguard Target Retirement Fund 2050 Fund” (symbol VFIFX).
Life cycle funds contain a blend of investments and it’s automatically diversified according to the year you want to retire. So, a life cycle fund for someone like me who has a long way until retirement will likely have a more aggressive blend of funds. Over time, the fund reallocates its funds, shifting to a more conservative portfolio.
You just keep putting money into this fund and you never have to rebalance it or diversify yourself — it’s done for you.
Related: Target Retirement Mutual Funds: T. Rowe Price vs. Vanguard @ My Money Blog
Not all life cycle funds for the same years are the same. For example, Vanguard’s 2045 fund has a different set of holdings than Fidelity’s, and so on. So, for your IRA it’s good to compare the specific asset allocation of each fund, and the expense ratio involved to see which offers the best investment for you. Some funds might be designed to be more conservative or more aggressive than another.
- How to choose funds in your 401k @ Oblivious Investor
- How I choose between limited 401k options @ My Money Blog
- Best funds you can buy @ CNN Money. Shows a variety of funds in several categories (large cap, small cap, international, bonds, etc.) and types of funds (growth, value, blend, etc.). Shows year-to-date returns, and the 5-year return, and expense ratios. Helpful starting point for comparing similar types of investments to one another.
- The essentials of investing in stocks and bonds for dummies @Dummies
Next week, we’ll talk about asset allocation — how to determine the percentage of each type of investment within your portfolio.
If you’ve written about retirement recently, be sure to submit your post to the Carnival of Retirement, as I’ll be hosting it here on Monday.