Chapter 13
Selecting Your Investments
IN THIS CHAPTER
Checking out your choices
Finding the right combination of investments
Keeping an eye on your pie
Knowing where to go for help
When you drive somewhere, what kind of ride do you like? A bumpy one that rises and dips like a rollercoaster, leaving you with a stomachache by the time you reach your destination? Or a smooth one that lets you arrive feeling rested and relaxed? Unless you truly enjoy discomfort, you probably prefer the smooth ride.
Investing for retirement is a lot like car rides. And I have news for you — diversifying your investments (choosing a range of different ones) puts you on a smoother investing path than not diversifying. How so? Different types of investments, such as stocks and bonds, tend to move up and down in value at different times. If you choose several investments, one may go down in value as another begins to go up, giving you a relatively even ride.
“Why not just put everything in the one investment that performs better than the others?” you ask. Great idea, in theory. But in practice, you can’t possibly know which investment will perform better than others. As all mutual fund companies will tell you, past performance does not guarantee future results. (They don’t tell you this just to be nice, either. They’re required, by law, to inform you of this.) Just because a fund performed well over the last year, or even several years, doesn’t mean that it will continue to do so if you invest all your money in it. (According to Murphy’s Law, as soon as you put all your money into it, it will do terribly.)
Your 401(k) plan probably lets you choose from many different investments, probably more than a dozen. How can you choose? You can close your eyes and point or throw darts, but that’s not advisable. What you need is a strategy.
This chapter outlines the main categories of investments likely offered by your 401(k) plan, how to compare and combine them so that they’re likely to keep increasing in value, and where to go for more help.
IRA investments are different because you have the sole responsibility for picking your investments, including where you set up your account. How and where you can invest is unlimited; however, the basic information about investing covered in this chapter also applies to IRAs.
Looking Over the Investment Menu
When your employer set up your 401(k) plan, it chose a selection of investments to offer. If you’re new to investing, the list may appear baffling — like trying to order dinner from a menu written in a foreign language. Although making a mistake while ordering a meal may set your stomach back for a day or two (pan-fried calves’ brains? Oops, I meant to order risotto!), choosing the wrong 401(k) investments can set back your retirement plans considerably.
Most investments offered by your 401(k) plan are likely mutual funds. Mutual funds pool together money from many investors and use that money to buy a variety of investments. Different types of mutual funds exist, such as stock funds, bonds, or other fixed-income (non-stock) funds, and money market funds, which are generally named after the type of investment they favor. Within those broad categories are more specialized mutual funds, as I describe in the following sections. Mutual funds give you an advantage as an individual investor because they let you invest in many more investments than you probably can on your own.
Your plan may also offer non-mutual fund investments, such as company stock or a brokerage window, which I describe later in this chapter.
Being broadly diversified may be the first and most important investment strategy. This means owning many different types of investments. Some investments do well even during times when many investments melt down.
However, broadly diversifying your investments isn’t likely to avoid significant losses when a major crash occurs like the one in 2008. Hopefully your losses will be less than what they would have been without a good diversification strategy.
Most 401(k)s also offer funds that enable you to be broadly diversified even though you are investing all your money in one fund. The most common of these funds is Target Maturity or Target Date Funds (TDFs). Each fund is designated by a year indicating our proposed retirement date, such as 2020, 2025, 2030, 2035, 2040, 2045, and 2050. TDFs are readily available for IRA investors.
As you look at your investment choices, you may wonder whether to invest a little bit in each fund or just choose the one that performed best during the past year. The answer is likely somewhere in between. Your job is to decide what combination makes sense for you.
How do you do that? First you need to understand the degree of risk and potential return of the investments. (I discuss these concepts in detail in Chapter 14.) Here, laid out roughly from lowest risk to highest (based on past performance), are broad categories of investments:
- Money market funds
- Stable value funds (not available to IRA investors)
- Bond funds (short, intermediate, long term, or some of each)
- Balanced funds including TDFs
- Stock funds
- Company stock (only available in 401(k) plans)
Looking at past performance of any investment option is of limited value because there’s no way of knowing how specific investments will perform in the future.
Money market funds: Show me the money
Money market funds are considered the least risky investments. They invest in very short-term debt instruments (called cash equivalents) issued by banks, large U.S. companies, and the U.S. government. A fund earns interest on the instruments it holds, but the instruments themselves do not increase or decrease in value. Your money isn’t expected to lose value in money market funds, and it will probably gain a bit.
These funds generally have low returns, and they shouldn’t be used for long-term investing because they probably won’t beat inflation over the long run. However, they can be a good place to park your money temporarily while you try to figure out what to do with it. Also, you may want to invest in one as part of a diversified portfolio if your plan doesn’t give you another fixed income (non-stock) option, or if you desire added stability, especially as you approach retirement.
Keeping things reined in with stable value funds
Stable value funds are fixed-income investments commonly backed by insurance companies or other financial institutions. Many 401(k) plans include these as conservative investments, but they aren’t widespread outside retirement plans. Their values don’t fluctuate the way bond funds sometimes do (see the next section).
You can consider these an alternative to bonds for the fixed-income portion of your investments. But remember that even though the word “stable” may appear in the name, they aren’t fully guaranteed. If an insurance company (or other financial institution) backing the investment fails, or if another asset held in the portfolio is in default, you may lose money. Also, your return can decline in a period of rising interest rates and increasing inflation. The long-term return of stable value funds has generally been below that of bond funds but higher than money markets.
Bonding your funds: Single portfolio seeks stable relationship
Bond funds invest in U.S. government bonds and/or corporate bonds (bonds issued by companies). The risk level and potential return of the fund depends in part on whether it holds more long-term bonds (that mature in 20 to 30 years), medium-term bonds (5 to 10 years) or short-term bonds (1 to 3 years). In general, funds holding mostly short-term bonds have lower risk and lower return than funds holding intermediate- and long-term bonds. Another factor that affects your investment results is the quality of the bonds the fund owns. Junk bonds have a potentially higher return but also potentially greater losses.
A fund company isn’t going to call its fund that invests in junk bonds a “junk bond fund.” It will more likely be called a “high-yield fund.” Read the prospectus or other material carefully before actually investing your money in any fund.
In a 401(k), you generally invest in a bond fund to add stability to your portfolio. Sticking to less-volatile short-term and intermediate-term bonds makes sense. The name of the fund may indicate what kinds of bonds it holds; otherwise, you can look at the list of bonds in the fund. (Short-term bond funds sometimes have “low duration” in their name.) Like stock funds, bond funds can be index funds or actively managed funds. I explain these terms in the section “Stock funds: A feather in your cap” later in this chapter.
Changes in interest rates can affect the return of a bond fund. (The relationship isn’t what you may think, though — when interest rates rise, bond values may decline, and vice versa.) In addition, a company that issues a bond (a corporate bond) may go kaput. If you invested in a fund holding those bonds, it can affect your return.
Some municipal bonds are tax-free investments — the interest earned isn’t taxed. Although these may be good investments outside of a 401(k) don’t buy them in your 401(k); you’ll be wasting the tax advantage. Money in a 401(k) grows tax-deferred, but you must pay income tax when you take money out, whether it was invested in a tax-free bond fund or not.
Deciding one and done: Balanced and TDF funds
Balanced funds and TDFs are mutual funds that invest in a set mixture of stocks and bonds and are generally designed for one-stop shopping. Investment professionals choose the balance of stocks and bonds for balanced funds. (The mix for balanced funds is usually around 60 percent stocks and 40 percent bonds, but the combination may vary.)
TDFs are a type of balanced fund aimed at a particular age group, based on the number of years until retirement. These funds are designed to be most effective if you choose one that’s right for you and invest only in that fund rather than mix it with other investments. For example, the investment mix in a 2040 TDF is what is thought to be an appropriate mix for someone who is expected to start withdrawing money from that fund in 2040. If you want an easy answer, pick the TDF that aligns with the year you think you may start withdrawing money. These funds are designed to make it easy for those who don’t know much about investing.
Stock funds: A feather in your cap
Stock funds, also called equity funds, invest mostly or entirely in the stock of U.S. and/or foreign companies.
Many factors influence individual stock prices, such as
- Political events in the United States and around the world
- Unpredictable events, such as the 9/11 attacks, natural disasters such as an earthquake, and a pandemic like COVID-19
- The company’s revenue and profits
- A change in company management
- New products recently introduced by the company (or a competitor)
- The company’s prominence within its industry
- The industry climate
- General market trends
- The opinion of large institutional investors, such as mutual fund managers
- The opinion of key analysts
Because so many things can impact the price of a stock, you may wonder why in the world you should invest your retirement savings in something so uncertain. The answer is that, historically, stocks have provided the highest average investment return over the long term. Also, by investing in a mutual fund rather than a single stock, you can reduce your risk level.
Active versus passive management
Some stock funds are index funds that invest in companies that make up a stock index. Many stock indexes exist; one of the best known is the Standard & Poor’s 500 (S&P 500), which is comprised of 500 large U.S. companies considered leaders in their fields (or economic sectors). Contrary to popular belief, the companies that make up the S&P 500 are not necessarily the 500 largest U.S. companies. The S&P 500 is often used as a broad measure of the U.S. economy.
Fees for index funds are generally lower than for managed funds, because index fund managers don’t spend a lot of time making decisions about what stock to buy and what to sell. Index funds are sometimes referred to as passively managed funds. (I give more examples of indexes in the section “Mistake #2: Comparing different types of funds” later in this chapter.)
An actively managed stock fund is a different cup of tea. This type of fund is run by a fund manager who tries to get better returns than the index that applies to the fund. (For example, the S&P 500 is an index for measuring the performance of large-cap stocks; I explain large-cap stocks in the following section.) The manager of an actively managed large-cap stock fund wants to earn a better return than the S&P 500, but they don’t? worry about doing better than a bond index, for example, because that’s a different type of investment. To beat the index, the manager needs to pick stocks that they expect? will do especially well. Because of additional operating costs in managed funds, the manager must beat the index by 0.05 to 1.0 percent in order for your return to be the same as if you had invested in an index fund. The fees for some actively managed funds are in excess of 2.0 percent. That’s a big hurdle. Studies show that most actively managed funds don’t beat the indexes over time: However, debates still rage in the investment world as to which is better — active or passive management.
You may decide to choose an actively managed fund, even if it doesn’t achieve as high a return as its benchmark, if the stocks selected by the manager have lower risk than those in the benchmark. The fund prospectus and third-party sources such as Morningstar or Value Line tell you how much risk the manager takes.
I prefer funds that have good historical returns but smaller up and down swings. The average annual returns commonly shown for each mutual fund won’t give you this information. You need to dig deeper by going into the fund prospectus or the website of the fund manager to get the actual return for each year the fund has been in existence.
Table 13-1 compares the latest returns of two actual funds over a ten-year span ending December 31, 2020. It can help you understand why just looking at average annual returns isn’t enough.
TABLE 13-1 Annual Returns Comparison
Year 1 | Year 5 | Year 10 | |
|---|---|---|---|
Year 1 | Year 5 | Year 10 | |
Fund A | 11.65% | 8.19% | 6.69% |
Fund B | 9.04% | 7.74% | 7.42% |
Fund A is an indexed 2015 TDF. Fund B is an actively managed fund. The one-year and five-year average returns may cause an investor to select Fund A, but taking the long view shows Fund B is the more profitable option. I also explain in Tables 13-2 and 13-3 that average annual returns aren’t the best way to evaluate funds.
Take a look at how different funds perform during sustained market downturns. The last one occurred in 2008, more than ten years ago. It’s easy to get the average annual returns for recent years, but you may have to do some digging on the fund company’s website to get historical yearly returns. It can be worth the effort to know how a fund rebounds — or doesn’t — after market stress.
Capitalizing on a company’s assets
Stock funds often concentrate on companies of a certain size or capitalization. (Capitalization, or market cap, refers to the number of shares on the marketplace multiplied by the price per share. If a company has issued 10 million shares of its stock and the stock is valued at $10 per share, the company’s market cap is $100 million.)
Generally, large-cap refers to companies with capitalization of more than $10 billion, such as Microsoft or Walmart. Small-cap companies have capitalization under about $2 billion, such as Twitter and Chipotle Mexican Grill. (Yes, I realize that $2 billion is hardly small change, but these definitions are relative. Kind of like the coffeehouse whose smallest size drink is labeled “tall.”) These definitions are somewhat fluid (different experts may use different cutoffs). What you need to know is that large-cap companies as a whole are considered less volatile investments than small-cap companies, which tend to be newer, less proven companies. However, small-cap companies are generally seen as having greater potential for growth (as well as for failure).
There’s also a mid-cap category for companies that are bigger than small-caps but not big enough for the big leagues. This category is very fluid. It may not be included in an asset allocation recommendation you get from an advisor, because a mix of large and small-cap companies may give you a similar investment result.
If you want to go whole hog, you can further divide stock funds into growth and value funds. (A mutual fund that mixes growth and value stocks is often referred to as a blend.) Here’s the skinny on growth and value funds:
- Growth funds invest in companies that are expected to earn a lot of money over a sustained period, such as some technology companies (Apple) or social media companies like Facebook. They generally plow their earnings back into the company rather than pay dividends to shareholders. The price of these stocks tend to be high compared to the companies’ earnings, but the expected revenue and profit growth attracts investors.
- Value funds invest in companies that are seen as bargains — their stock prices are low compared to their assets, revenues, and earnings per share. The stock price may be low because the company is in a sector (part of the economy) that is going through a slump but is expected to recover, such as energy companies or some telecommunications and technology companies in 2002 (ExxonMobil or Comcast, for instance). Another reason for a low stock price may be that the company or industry has fallen out of favor with investors for a reason unconnected to its performance — similar to a fickle public’s treatment of some rock stars and professional athletes.
Put all those categories together, and you end up with funds called “Company X Small-Cap Growth” or “Company Y Value Equity.” The first would likely invest in small-growth companies, and the second in value stocks — potentially from a company of any size.
There’s obviously a lot more to a mutual fund than its name. In fact, the name may be misleading. You should look at the fund’s prospectus (a description of the fund that you can get from your employer, plan provider, or the fund company) to see where the fund is invested. Small-cap growth funds may also have investments in bonds and cash. Why does that matter? Say you’ve figured out that 15 percent of your money should be in bonds, and you’ve already invested that much in a bond fund. If the stock fund you invest in also holds bonds, you’ll end up with more bonds than you want, which probably means a lower return over the long run.
You should also check how an independent third party such as Morningstar or Value Line identifies the fund. (I explain more about these and other services in the “Seeking Help from the Pros (and I Don’t Mean Martha Stewart)” section at the end of this chapter.)
International investing
Your 401(k) plan may offer a mutual fund (or funds) that invests in companies outside the United States. Foreign investments may move up and down at different times from the U.S. stock market, meaning that international investments can help diversify your portfolio. An “International” fund generally invests only in non–U.S. companies, while a “Global” or “World” fund may also include U.S. investments.
International funds may be named after the specific region they invest in: Europe, the Pacific Rim, Latin America, or Emerging Markets (developing economies), for example. Be sure to research any fund (before you invest in it) to find out exactly what it holds. Also, read up on the politics and economics of the countries the fund invests in — instability increases the risk to your investment. For example, Emerging Markets investments generally are riskier than investments in developed economies such as Europe.
Investing where you work: Company stock
Your 401(k) plan may let you invest your contributions in your employer’s stock. Although doing this can seem like a good idea, especially if your company is the greatest, think twice before you decide whether to do it. Company stock isn’t a diversified investment such as a mutual fund. Although your company’s stock may do really well, it can also do really badly at some point and wipe out your entire nest egg if you invested it all in company stock. Remember your parents’ admonition about not playing with matches? It’s the same with company stock. Hold it too long, and eventually you’ll get burned.
I don’t recommend investing any of your own 401(k) money in company stock. Having a large portion of your savings in company stock is a disaster if the company goes out of business. You can lose your job and much of your retirement savings at the same time. If your company offers a stock purchase plan — a plan that permits employees to buy company stock at a discount — go ahead and buy some stock for your personal portfolio; just don’t put it in your 401(k).
If you have a lot invested in your company’s stock, it may pull your entire account down, even if you also have money invested in mutual funds. Many financial planners advise holding no more than 10 percent of your retirement investments in company stock (including the portion your employer may give you as a contribution), and some encourage investors to sell all their company stock and buy mutual funds instead (if their plan’s rules allow them to follow this advice).
Brokerage window: Don’t fence me in
Like cowboys living out on the range, some 401(k) investors don’t like to be fenced in. They want to invest in more than just the options chosen by their employer. To make these employees happy, some companies offer a brokerage window (sometimes called a self-directed option). This isn’t really a class of investment, but I include it here because it’s a way of investing in a 401(k) plan that is becoming more common. The “window” may let 401(k) participants invest in any stock, bond, mutual fund, or exchange-traded fund they like, not just the ones offered by their plan.
For more info, check out “What Is an ETF? A Beginner’s Complete Guide” by Kevin Voight at NerdWallet, www.nerdwallet.com/article/investing/what-is-an-etf.
Using a brokerage window or nontraditional investments puts more responsibility on you to research your investments to make sure that they’re right for you. I recommend getting help from a reputable advisor if you choose to go this route.
Broadening 401(k)s
If your plan offers a brokerage window, you probably have to pay extra for it. Also, some companies don’t give you complete freedom, because they don’t want you to use a brokerage account to day-trade (buy and sell investments frequently, trying — and usually failing — to make a quick buck) or to invest all your 401(k) money in a single stock. I advise employers who offer a brokerage window to limit investments to professionally managed mutual funds.
Your employer may set up a 401(k) where each participant has their own brokerage account. An independent recordkeeper is needed to do that. (Chapter 18 contains information about independent recordkeepers.) With an independent recordkeeper, employers may also allow participants to invest in non-traditional investments such as real estate. I am not encouraging doing that, but it’s legally possible.
Feeling free with IRAs
IRA investors can open their accounts where they have access to a brokerage account without having to get anyone’s approval. You have complete freedom to open the account wherever you want, including the opportunity to invest in nontraditional investments. Traditional investments are those that are liquid and are traded on any of the many market exchanges such as the New York Stock Exchange, Nasdaq, London Stock Exchange, and the Japan Stock Exchange.
IRAs with access to a brokerage account may be opened at stock brokerage firms like Charles Schwab, E*Trade, TD Ameritrade, and so on. They also may be opened at some of the large mutual fund companies like Vanguard and Fidelity.
The only prohibited investments for IRA investors are life insurance, collectibles, and real estate you live in. Permitted investments for 401(k) participants are a bit more restrictive because these plans are subject to ERISA’s fiduciary rules. These rules require that all investments must be selected by the employer considering what is in the best interest of the participants. Any self-dealing is also a prohibited transaction.
Nontraditional investments include things that are not traded on stock or other exchanges. For example, you’re permitted to buy real estate provided you don’t live in the property you purchase for your IRA account. You can buy gold and other precious metals, cryptocurrency, and so on. Having your IRA own an LLC is another possibility, but this one is more of a stretch with possible serious ramifications. I am not suggesting these investments, but I would be remiss if I didn’t let you know that they are possible.
Making such investments provides an opportunity for broader diversification but should be considered for only a portion of your retirement funds after you build a rather large nest egg.
If you want to do nontraditional investing with an IRA, you need to set up an IRA account using a custodian that enables you to make such investments. It is imperative to select a custodian that has lots of these types of IRA accounts and that has been in business for many years. The Retirement Industry Trust Association (www.rita.org) provides services to this type of custodian, and they also have some standards that members must follow.
I also found The Entrust Group’s website to be helpful when I was looking for information about this type of custodian. Their fees and a lot of other useful information is on their site at www.theentrustgroup.com.
Forging Your Own Investment Trail
Different types of funds serve different investment objectives. Broadly speaking, objectives can include growth (capital appreciation), income, and capital preservation (which I explain in just a second).
Long-term investors (those with at least ten years before they may need the money) usually invest primarily for growth. When you invest long term, you don’t want an immediate return such as interest or dividends. Instead, you want your investments to increase in value, so that when you’re ready to sell them, they’ll be worth a lot more than you paid for them. You’re willing to take on a certain amount of risk for the possibility of a higher return. The most common investment for this type of strategy is stocks — of all kinds.
Within five to ten years of retirement, you can cut back your level of stocks by shifting into less volatile investments, such as bonds and stable value funds, to reduce your risk. You may also shift the remaining stock portion of your portfolio from more risky stocks (generally growth-oriented companies) to less volatile ones (generally value-oriented companies). This is a capital preservation strategy. You want your money to grow at a rate that will at least beat inflation, but you want to reduce your risk of losing money. The long-term return of this portfolio will probably be lower, but at this point, you’re more concerned with preserving your capital.
Some retirees who are very concerned about preserving capital during their retirement years typically invest to generate an income through interest and dividends. A problem with this strategy is that you have little or no hedge (protection) against inflation. In addition, you can’t count on companies that pay high dividends to always do so. Dividends are one of the first things to be cut when profits shrink. You need income during your retirement years, but you can collect it in other ways. I recommend using an automatic withdrawal plan from mutual funds or an annuity rather than trying to find investments that will generate enough income through interest and dividends. In any case, you should probably still keep at least 25 percent of your money in stocks, because retirement can last for 20 years or more, and your money needs to keep growing.
Baking Your Asset Allocation Pie
Figuring out the right investments for you is an important part of 401(k) and IRA investing. It requires some time at the outset, but when you’re done, you shouldn’t have to spend too much time on managing your account, except for periodic maintenance.
The first step is to figure out what percentage of your investments should go into the different asset classes. The five asset classes that are generally used are large-cap stocks, small-cap stocks, international stocks, fixed income (bonds and stable value funds), and “cash” (money market funds). Pie charts are the financial planners’ preferred method for illustrating asset allocation, or how to divide your money among different investments. Figure 13-1 shows a sample allocation for someone 25 years from retirement who is a moderate investor (not too conservative, not too aggressive).
FIGURE 13-1: Pie chart with 55 percent large cap, 20 percent bonds, 10 percent small cap, and 15 percent international.
Everyone’s situation is unique, and the sample allocation shown here may not necessarily represent the right strategy for your situation. You may need or want something more aggressive (riskier) or less risky. These are guidelines to put you in the ballpark — whether you end up sitting behind home plate, in the bleachers, or somewhere in between is up to you.
The right asset allocation for your situation depends on a number of factors, including your time horizon, retirement goals, and comfort level with investment risk. It also depends on whether you expect your 401(k) or IRA to be your principal source of retirement income, or whether you have other substantial resources to rely on, as well. (If you have other resources, you may be able to take less risk with your 401(k) or IRA and still meet your retirement goals.) You and your next-door-neighbor may both be 25 years away from retirement, but she may require a more conservative portfolio, while your situation may warrant one that’s more aggressive.
For example, someone with a 25-year time horizon who doesn’t mind investment risk may decide on a 401(k) allocation that’s 100 percent stocks, as shown in Figure 13-2.
FIGURE 13-2: Pie chart showing 65 percent large cap, 15 percent small cap, and 20 percent international.
Someone else with the same time horizon who is risk-averse may move more into bonds and even a money market (cash) investment, as shown in Figure 13-3.
After you determine an appropriate asset allocation for you, the next step is to determine which funds in your 401(k) plan and those available with your IRA match up with the asset classes you want to invest in, and decide which funds to invest in. The following section, “Check your ingredients and avoid these common mistakes,” gives some tips for choosing investments.
How you go about completing these steps depends on whether you prefer to do things yourself or seek professional advice, as well as on what resources are available to you at work. In the “Seeking Help from the Pros (and I Don’t Mean Martha Stewart)” section at the end of this chapter, I give suggestions for where you can go for help.
Another option is to put all your money into the Target Date Fund that aligns with the year you expect to start withdrawing money — the 2035 TDF, for example.
FIGURE 13-3: Pie chart with 50 percent large cap, 5 percent small cap, 10 percent international, 30 percent bonds, and 5 percent cash.
Check your ingredients and avoid these common mistakes
When you decide on an asset allocation, you need to split your money among the funds available in your 401(k) to achieve the desired allocation. If you have already contributed money to your 401(k), you may need to move it into different funds to achieve the mix that you want. You should also make your new contributions in these proportions.
With a 401(k), you can move money among investments without paying fees. Most plans let you move money when you want to by using your service provider’s website. You can also change your IRA investments by accessing your IRA account online using the website of the financial organization that holds your account.
When choosing specific funds, be sure to focus on the right information. Following are some common mistakes 401(k) and IRA investors make.
Mistake #1: Basing investment choices on the past performance of the investments
Good results are often fleeting. Many of the funds that appear on “Top 10” lists aren’t repeat stars.
Many technology funds were top performers prior to 2000. They then dropped into the worst-performing category in 2000 and early 2001. One mutual fund that invested in small Japanese technology companies gained 100 percent during the first six months of 1999 and 114 percent in the second half of 1999. If you were shopping around for a fund back then, boy, would that have looked like a winner. But (there’s always a “but,” right?) when technology companies took a dive in 2000, the fund dropped by 71.8 percent. If you’d been paying attention to analyst predictions about the tech sector and had looked at the companies held by the fund, you would’ve been forewarned. You probably would have chosen another fund and ended up better off. That said, I ran across an internet message board with entries from three investors who were in the fund in April 2000, when the fund was nosediving. Two of the three said that they were hanging on to the fund because they thought it would go back up. (The fund no longer exists, by the way.)
The potential exists today for some major downturns. For example, growth stock index funds were up 64 percent during the past year and an average of 25 percent for the last five years. Bitcoin increased in value from $1,290 on March 2, 2017, to $54,806 on March 17, 2021. It is highly unlikely that similar levels of growth can be sustained; therefore, investing new money into these types of investments today chasing their recent returns may be a bad idea.
Mistake #2: Comparing different types of funds
You can’t compare apples with oranges, and you can’t compare stocks with bonds. You must compare a fund’s performance to that of others in its peer group (similar types of funds).
Identifying a fund’s type can be difficult. The name won’t always help you. Looking at a prospectus for the fund should help you figure out a fund’s type, but it still may not be totally clear. An independent source, such as Morningstar or Value Line, can be your best bet for finding out what the fund invests in.
To measure your mutual fund’s performance against a standard, use an index. Indexes are made up of a large number of companies that fall into the category being measured, so they provide a good indication of how the category is doing.
You need to make sure that you measure the mutual fund’s performance against the appropriate index. In general, you can measure
- Large-cap stock funds against the S&P 500 or Wilshire 5000
- Small-cap stock funds against the Russell 2000
- International funds against the MSCI-EAFE (Morgan Stanley Capital International Europe, Australasia, Far East Index)
- Bond funds against the Lehman Brothers Aggregate Bond Index
The financial institutions listed also have a number of more specialized indexes for measuring performance of specialized funds such as large-cap growth, small-cap value, and so on.
Mistake #3: Failing to look at both short- and long-term performance
Compare the fund’s most recent returns, and also longer-term (three- to-five-year) performance, with that of other funds from the same category. Looking at long-term results helps you tell whether the fund is relying on one good year for its overall good performance.
Mistake #4: Assuming that the fund with the highest average return will give you the most money
This is not necessarily the case, believe it or not. For proof, look at the year-by-year comparison of two different funds in Table 13-2.
TABLE 13-2 Net Annual Return Comparison (In Percent)
Fund | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | 3-Year Avg. | 5-Year Avg. |
|---|---|---|---|---|---|---|---|
A | 35.3 | 22.4 | (–8.7) | 18.5 | (–7.6) | 16.33 | 11.98 |
B | 21.1 | 17.3 | (–0.5) | 13.2 | 2.7 | 12.63 | 10.76 |
The natural assumption from looking at the numbers listed in Table 13-2 is that Fund A is better because its five-year average return is 11.98 percent, which is higher than Fund B’s return of 10.76 percent. However, you arrive at a different conclusion when you look at Table 13-3, which shows the dollar amounts you’d accumulate in both funds if you invested $10,000 in each at the beginning of each year.
TABLE 13-3 Amount Accumulated With $10,000 Annual Investment (In Dollars)
Fund | Year 1 (end) | Year 2 (end) | Year 3 (end) | Year 4 (end) | Year 5 (end) |
|---|---|---|---|---|---|
A | $13,530 | $28,801 | $35,425 | $53,829 | $58,978 |
B | $12,110 | $25,935 | $35,755 | $51,795 | $63,463 |
Looking only at percentage returns (Table 13-2), Fund A would have appeared in the winner’s circle after the first three years, with a 16.33 percent average annual return, while Fund B’s 12.63 percent average three-year return probably would have attracted little or no attention. But Fund B accumulated a slightly larger amount than Fund A after three years (Table 13-3). The difference is even more dramatic after five years.
After five years, Fund A achieved an 11.98 percent average return compared to 10.76 percent for Fund B, but the dollar amount accumulated in Fund B is 7.6 percent more than Fund A!
The essential things to keep in mind about watching performance over time are
- A fund that has less dramatic ups and downs can perform better than a more volatile fund.
- Average performance results are of limited value.
- Don’t consider “Top 10” listings the final word. Find the funds that can sustain top performance.
- It can take a long time to get back to where you were after a bad year.
The last point of the list is especially important. Assume, for instance, that you have $100,000 invested in a fund that drops 20 percent to a value of $80,000. A 20 percent gain the next year brings your value up to $96,000. But you’re still 4 percent behind. If you’re counting on an 8 percent annual return to get you to your retirement goal, you have a lot of ground to make up. Your $100,000 at the beginning of this two-year period would have to be worth $116,640 to be on track, but it’s worth only $96,000 after the recovery. You need a 31 percent gain the third year to get on track, which is highly unlikely.
The combination of setting unrealistic return expectations and picking funds that don’t do well during down markets may eventually result in a serious gap between what you need to save and what you actually have in your account. Somewhere along the way, you need to make up for the investment gains that didn’t occur. This is another reason why it makes sense to pick funds with less dramatic ups and downs.
In the final analysis, the funds you choose must meet your personal objectives. You’re not always going to follow conventional wisdom — you need to make informed investment decisions that are right for you.
Open the oven door once in a while to check your progress
After you develop your asset allocation pie, leave it alone but don’t ignore it completely. Check it at least once a year to see whether you need to rebalance, or bring your investments back in line.
To take a simple example, say you have 75 percent in stocks and 25 percent in bonds. Say stocks take off and do really well. The stock portion of your account increases in value at a much faster rate than the bond portion, to, say, 85 percent of your total account. The bond portion is now worth only 15 percent of your total account. You’re in a position to lose a lot of money if the stock market drops — more than if you had 75 percent in stocks. You need to sell some stocks and use the money to buy bonds to move your account back to a 75/25 split, if that’s the right asset allocation for you. You may not want to do this, because your stocks have been doing so well, but it’s the right thing to do.
Studies show that many participants never rebalance their 401(k) or IRA accounts. Many workers over age 55 entered the market slump that began in 2008 with a higher percentage invested in stocks than ever in their careers. They lost a lot of money from their accounts because they didn’t rebalance. In fact, at their stage in life, they should have actually gone one step further and reallocated, or changed, their fundamental asset allocation. They should’ve reduced their stock investments to a lower level than when they joined their plans. For example, a 50/50 split of stocks and bonds would be more appropriate for a 60-year-old than a 75/25 split. If the participant had 85 percent in stocks, the unfortunate result would be greater losses than they should have had.
Another advantage of TDFs is that they automatically rebalance your investment mix so you don’t have to do it. They will also reduce your stock exposure as you get older. Check your TDF to see when they do both these things.
After you determine an appropriate asset allocation, you probably shouldn’t change your allocation pie unless a major life-changing event occurs, such as inheriting a million dollars, winning the lottery, or approaching retirement age.
Make sure that your pie complements the rest of the meal
One of the cardinal rules of planning a menu is that, if you serve a main dish with a crust (such as Beef Wellington or quiche), you shouldn’t serve pie for dessert. Otherwise, you have too much crust for one meal. Likewise, make sure that your 401(k) and IRA investments go well with other investments you have. They should balance as a whole.
For example, say your company matches your 401(k) contribution in company stock, and you’ve built up quite a lot of it — 50 percent of your 401(k) balance. Assume that you can’t change this distribution, because your employer requires you to hold the stock until you turn 55, and you’re only 40. You also buy additional shares through a stock purchase plan. What can you do? You should count the company stock as a high-risk stock investment when you decide how to invest your own contributions to your 401(k) and try to use your own contributions to adjust your overall risk to a more comfortable level.
You should also take into account how you’re investing in your IRA or outside savings account. If you’re married, you can look at your 401(k) and your spouse’s as one investment and compensate for the aggressive company stock investment in yours with more conservative investments in your spouse’s account.
You should also take into account any guaranteed retirement benefit payment that you expect from your employer with either a defined-benefit or cash balance pension. With a defined-benefit plan, you may receive a regular defined payment when you retire. Having either of these plans gives you room to invest your 401(k) money somewhat more aggressively, but only if you’ve been, or expect to be, with your employer for enough years to qualify for a significant pension payment. (That may be quite a few years.)
Of course, things can change very quickly. Your company may change or terminate the plan, the company may be sold or go out of business, and so on. Your investments should be reevaluated if changes such as these occur.
Seeking Help from the Pros
A common mistake 401(k) participants make is to randomly pick their investments without any idea of what they’re investing in or why. Becoming informed about investing doesn’t necessarily require a major time commitment.
Finding books and publications
You can buy, or borrow from the library, a number of books that cover the basics of investing, starting with the latest editions of Investing For Dummies and Mutual Funds For Dummies, both by Eric Tyson (Wiley Publishing). Many public libraries also carry investing resources, such as mutual fund reports from Morningstar and Value Line, which are packed with information, including various funds’ holdings, risk levels, and past returns. You may also want to talk to friends who seem to be successful investors and ask them what resources they find helpful.
Consulting a real live person
Investing is like any other life experience — the result usually depends on the effort you’re willing to put into it. If you’re like me and most other retirement savers, you don’t have a lot of time to manage your investments. (That’s why you’re reading this book and not a 500-page tome on the theory of investing, right?) Consider getting professional investment advice. Your plan may offer advice, or you can get advice independently from outside your plan.
An advisor can analyze the funds offered by your 401(k) plan and match up a specific investment recommendation with your risk tolerance and goals. The advisor will recommend exactly how much you should invest in each option and also whether you need to move around what’s already in your account.
With an IRA you will probably be charged a wrap fee, which pays for the financial advisor. An advisor who is part of a large financial organization, investment firm, or bank usually puts your money into a canned investment package. Canned means they are tightly controlled by their employers and are typically able to offer a limited number of pre-packed alternatives. These alternatives are similar to the asset allocation mixes of TDFs, but the total fees are usually in the 1.5 to 2.0 percent range for the same type of investments you can get on your own for less than 0.10 percent. The fee for Charles Schwab’s index TDFs is only 0.08 percent. You can easily access them by entering “Charles Schwab target date funds” in your browser. Vanguard is another good choice with TDF fees in the 0.13 to 0.15 percent range. One sure way to improve your investment return is to reduce the fees you pay. In my opinion, paying an additional 1 to 1.5 percent or more fee for an advisor isn’t worth the added cost.
Vanguard and Charles Schwab both also offer investment advisor services. Vanguard’s fees are currently 0.30 percent up to $5 million and 0.20 percent over $5 million and under $10 million. Charles Schwab’s fees currently vary depending on the type of services you receive.
You can also select an investment advisor who lives in your area. I recommend one who operates independently rather than being limited to canned solutions dictated by the firm the advisor works for. By “canned,” I mean the typical eight to twelve portfolios that are offered to all investors. Each investor is placed into one of these portfolios.
TDFs are canned portfolios that have roughly the same investment mix as those offered by non-independent investment advisors, without the additional fees. The fees for canned portfolios offered by non-independent advisors range from 1 to 1.75 percent compared to 0.08 percent for Charles Schwab’s TDFs.
Another real-person option is to find an independent advisor who is able to provide customized services to fit your situation. Clear View Advisors is an example in my area.
Determine whether the advisor makes money by advising you to invest in a particular fund or funds. Some are independent, or fee-based, while others earn a commission on what they sell. Possible sources for finding a good advisor include the following:
- Word of mouth — but make sure that you ask people who seem to be doing well, not your colleague who’s always asking to borrow five bucks.
- Professional associations or companies, such as
- The National Association of Personal Financial Advisors (
www.napfa.org) - The Financial Planners’ Association (
www.fpanet.orgfor the FPA Planner Search) - Dalbar, Inc. (
www.dalbar.com) for company information
- The National Association of Personal Financial Advisors (
Going online for info
Many resources for retirement investors are available online including robo advisors, which I cover in the next section. For asset allocation and fund allocation advice, you can look at independent online advice providers.
Each online advice provider has a different presentation, fee, and technology, but they all gather information about you and make a specific recommendation for how to invest your money. You can either take the recommendation as is, or compare it with one you’ve come up with on your own.
You can also find mutual fund reports by Morningstar and Value Line on their websites — www.morningstar.com and www.valueline.com, respectively. Value Line charges a subscription fee, and Morningstar asks you to register with its site. (Morningstar also charges for certain services.) Both companies rate mutual funds, but keep in mind that the ratings are based on past performance, which is no guarantee of how the funds will perform in the future. Another resource for mutual fund information is Charles Schwab, a large online broker. Go to www.schwab.com and click on “What We Offer” then “Mutual Funds” to see how Schwab classifies various funds.
Going online for advice
Robo advisors are a class of financial advisors that provide financial advice online with moderate to minimal human intervention. A robo advisor uses computer algorithms and advanced software to build and manage your investment portfolio. Wealthfront, Vanguard, Fidelity, Charles Schwab, Stash, and Betterment offer this type of advice, as do many of the other large investment firms.
A $3,000 minimum balance is required for Vanguard Digital Advisor service, and their current fees are about 0.15 percent annually. Charles Schwab requires a $5,000 minimum balance for its Schwab Intelligent Portfolios, and there currently isn’t any fee. A $25,000 minimum balance is required for Schwab’s Premium service. Charges entail a $300 initial planning fee plus $30 per month for unlimited guidance.
Whatever you do, remember that investing is not an exact science. The important thing is to do something, and make sure that what you do is reasoned. Even when you use an advisor, you should know enough about investing to determine whether the advice you’re getting makes sense.