This is Part 2 of the Retirement Planning series. In Part 1 we covered what a retirement account is and some of the basic account types available.
One of the more confusing things about retirement accounts is choosing where your money will go. After reading this post you should have a better idea of what you’re looking at when you are picking investments for your account.
Side note: this post is mostly in regards to mutual fund investments. If you are investing in individual company stocks with your IRA then you probably have a different approach to investing, and may find this article less useful.
Asset Allocation
At the broadest level, a mutual fund will cover one of the major asset classes: stocks, bonds, commodities, and real estate. Each asset class has it’s own risk and return characteristics that you should keep in mind when investing. The general rule of thumb is that riskier investments have higher returns, and that the longer your investment horizon the riskier your investments should be. The thinking behind this is that a longer time horizon gives you a larger chance to realize the higher returns.
Bonds are generally considered to be the least risky investment, but also the lowest returning. Stocks have historically had higher returns than bonds, but have higher swings up and down. Commodities, such as gold or crude oil, have the most risk, but can also exhibit large price swings. Real estate can be anywhere on the scale due to its unique characteristics. Most 401(k)s will have many stock fund options, a few bond options, and a money market (cash) fund. Commodity and Real Estate funds will be available for IRA accounts through a company like Vanguard or Fidelity.
When choosing investments for your retirement account you should consider the time until you retire. A person in their 20’s may decide that they want to have only risky investments with no low risk investments, with the hope to maximize their return potential. Someone closer to retirement may want to have more money in cash, bonds, and dividend paying stock funds, and less in risky investments so they don’t risk money they will need in a short timeframe.
Asset Allocation At Another Level
Once you’ve decided on the appropriate percentage of your account to allocate to stocks, bonds, and other investments, it’s time to break the allocation down further.
Company stocks are categorized into market capitalization groups. Capitalization is a fancy word for the size of the company. This means that based on size, a company’s stock will fall into micro cap, small cap, mid cap, or large cap. Market cap is calculated as the share price times the number of shares outstanding. To capture a broad range of stocks you should choose a fund from each of these groups to include in your stock portion.
In addition to capitalization, stock funds can be broken up into domestic and foreign. Foreign stock funds will have names like Euro-Pacific or Emerging Market. For now I think it’s important to diversify into foreign companies, especially considering the slide of the U.S. dollar.
Bond funds often have many types available as well. The most common types include total bond funds, high-yield bonds (called junk bonds by most), and government bonds. Again, each type of fund will have it’s pros and cons. High-yield bonds will have higher yields (obviously), but they will exhibit higher price swings similar to stocks. Government bonds will usually have lower rates, but should have less risk since their cash flows are backed by government agencies. A total bond fund will cover a range of all bond types.
Expense Ratios
While you can’t control the returns of your investments, you can do your best to minimize losses. The two biggest return robbers are taxes and expenses. Since retirement accounts are non-taxable, you have already eliminated the first issue. The second, expenses, is a little tougher to control for.
An expense ratio is the amount of money that the fund charges to manage your money. If the ratio is 1% then the fund will keep 1% of your money every year. It doesn’t sound like much, but over the long term any amount will hurt your returns due to the effects of compound interest.
Typically index funds will have the lowest expense ratios. Actively managed accounts run by a portfolio manager will have much higher expense ratios. It’s up to you to determine whether you think the expense is worth it. I personally try to stay with index funds as much as possible, due to both expenses and my belief that most managers cannot beat the market consistently (a topic for another post).
What About Lifecycle Funds?
One of the newest products of the mutual fund industry is the lifecycle fund. These types of funds give you an easy way to diversify, especially if you only have one account and all of your money is in that one lifecycle fund. A lifecycle fund will typically invest your money in a mix of stocks, bonds, and cash, depending on what year you specify for your retirement. As the retirement date approaches the ratio of cash and bond investments increases, and the amount of money in stocks goes down.
Sounds great, right? The downside to these funds is they generally have higher expense ratios than if you simply invested in a stock and bond fund yourself and handled the rebalancing yourself every year. The lifecycle fund options in my wife’s 401(k) had expense ratios around 1%, fairly high considering the index fund options all had ratios under 0.5%.
How Should I Pick Funds?
The absolute worst way you could choose funds is to pick the ones with the highest historical returns. Instead you should consider the advice above. A typical 401(k) plan or IRA mutual fund list will have funds that fall in the categories we just talked about. Start by thinking about your investment timeline and choosing the appropriate risk level. Decide what percentage you would like to devote to equities, what percentage to bonds, and what percentage to devote to cash. If they are available, also decide if you will contribute to a commodities or real estate fund.
Once you’ve determined a percentage to devote to stocks, decide what percentage will be domestic, and what percentage will be foreign. Choose ONE fund for each of the asset classes. For example choose one small cap fund, one mid cap fund, and one large cap fund. As I said before, if index funds are available I recommend choosing them. But you may decide another fund offers better prospects.
Do the same thing for your bond allocation. Determine an amount to put into high-yield, government, or any other bond funds that are available. Try to mix it up between high risk and low risk, just like you did with the stock funds.
You’re done!
If you follow these steps you should be able to create a diversified portfolio that covers a broad spectrum of investments. You should also have a better understanding of what is going on with your portfolio when you see month to month fluctuations. I realize this is an incredibly broad topic to cover, enough that an entire book has been written about it. But this should be enough for you to look at the funds available to you and determine what class they fall into. Next week will be part 3 of the retirement series, so keep on the lookout!
