Selecting funds for your retirement account can be frustrating. You’re faced with an overwhelming amount of financial jargon, paired with tremendous pressure to make the best decision given the importance of your retirement investments. Several of you have asked me to take this topic on directly, so let’s explore how to navigate retirement account fund selection!
Before we dive in: If you’d like a quick orientation to investing, explore how to start investing in four steps. And, if you’d like clarity on 401(k)s and IRAs, review this overview of the main differences in these common retirement accounts.
So, how do you choose funds for your retirement account? I’ll take you through four steps:
Decide how much of your retirement investments will be in stocks (versus other investment types)
Identify mutual funds that might meet your needs
Select the funds that are right for you (low-cost and with a strong performance history)
Invest (consistently and automatically) according to your asset allocation
Let’s start with the first step - identifying the portion you’d like to invest in stocks. When you contribute to a retirement account, you need to decide how that money will be invested. This is referred to as “asset allocation.” How much will you invest in bonds (which are generally lower-returning but more stable)? How much will you invest in stocks (which tend to return more, but can be riskier)?
The asset allocation decision can seem overwhelming to many of us, who want to get the answer “just right.” However, like so much with investing, there is no perfect strategy. I suggest using one of two methods to derive your answer.
Rule of thumb. Many advisors suggest that subtracting your age from 110 provides the percentage of your portfolio you should keep in stocks. For example: If you are 29, 81% of your portfolio should be in stocks, and the remaining 19% should be in less-risky investments like bonds or cash. (Note: Advisors used to subtract from 100; I now see many shifting to 110 or 120 given longer lifespans.)
Online questionnaires. Financial institutions have easy-to-use questionnaires that help assess your risk tolerance, investment time horizon, and other elements in order to provide you with a recommendation. These questionnaires will provide a suggestion for you to consider regarding your asset allocation.
Note that most employer-sponsored retirement accounts will not permit you to invest in individual stocks. Instead, you can purchase large groups of stocks at one time by buying mutual funds. I generally like this limitation, as I do not believe the average person (or even most investment professionals) can outperform a well-designed, low-cost mutual fund. Therefore, once you determine the percentage you’ll be investing in stocks, you’ll usually be purchasing mutual funds (made up of stocks), instead of individual company stocks themselves.
Next, you need to identify the mutual funds available in your retirement plan that might meet your needs. Typically, most employer-sponsored retirement accounts limit your investment options, providing you with a list of mutual funds to select from. You can learn more about mutual funds here; since mutual funds allow us to buy many, many investments in just one purchase they are a very convenient way to invest.
When you are provided with a list of mutual funds, it will typically include the fund name and the ticker symbol, so you can easily research it. This is another step that can feel very overwhelming, and I recommend four steps to narrow your list of mutual funds down:
Avoid mutual funds that bet on an industry or sector. If you not 100% certain that a specific industry is going to over-perform all others, why would you place your valued money in that mutual fund? I avoid any funds that overemphasize a particular industry or region.
Explore target date funds if you like to keep things simple. Target date funds are designed to make asset allocation (which we discussed in the first step) easier. They are designed to get less risky as your retirement date nears, shifting from stocks to bonds. Note that, generally, their returns also drop over time (as they shift from higher-returning stocks to lower-returning, but more stable investments). Target date funds are named with the retirement year - so, if you’re 30 and plan to work until you’re 50, you add 20 years onto today’s date and select the fund with that year in the title.
Call your retirement account provider. Many retirement account providers (like Vanguard, Fidelity, and Charles Schwab) also offer support in identifying and exploring investment options. Taking some time to speak with them may provide additional clarity.
I suggest considering 3 - 6 mutual funds, with no more than two bond (or fixed-income) funds. Fewer funds reduces complexity and allows you to better understand what you’ve decided to invest in.
At this point, you have a list of several funds, and need to finalize your investments by checking costs and performance histories. Before investing, you should examine the 3 - 6 mutual funds you’ve identified to confirm they are low-cost and have a strong performance history relative to benchmarks.
I recommend you check at least three things; All should be available via your financial provider, but you can also search the funds on an industry site like Morningstar.
What's the expense ratio? This is how much the company that manages the fund charges you for their work. An average expense ratio is around .6% - meaning, for every $100 you have invested, the fund rakes in 60 cents. Sounds small - but tiny fees make a meaningful difference in your wealth over the long term. Vanguard’s average expense ratio is .12% - meaning, for every $100 you invest in a Vanguard mutual fund, they charge 12 cents. That’s much, much lower, and lets you keep more of your hard-earned money.
Are there other fees? It can be costly to create fancy, actively-managed mutual funds. So, look carefully for purchase or redemption fees, or 12b-1 fees (marketing or distribution fees.) Ask, ask, and ask again about fees before investing!
What's the 10-year return? If you’re investigating a stock fund, you’ll want to explore how it performed over the last decade, compared to the S&P 500. The S&P 500 is a very common performance benchmark because it includes the 500 largest U.S. companies. If the mutual fund seriously underperformed the S&P 500, it may not be worthy of your hard-earned money.
You’ll also want to compare each investment you are considering to one other; if an investment has a particularly high expense ratio, or low return relative to others in your short list, you may decide it isn’t worth investing in.
Finally, invest (consistently and automatically) according to your asset allocation. Remember your asset allocation? Well, now that you have your 3 - 6 total mutual funds, you will need to determine exactly how to invest across each fund.
Let’s say you have selected three funds, an S&P 500 index fund, a broader market index fund, and a bond fund. Further, let’s assume you’ve already determined you’d like to invest 10% in bonds and 90% in stocks. Then, your only remaining decision is how to divide that 90% between the two stock funds (the S&P index fund and broader market index fund) - as 10% will go to the bond fund. In a situation like this, my suggestion is keep is simple - so, start with a 50/50 split between the two stock funds, unless there is a compelling reason to do something different.
Most retirement account providers will allow you to allocate your investment dollars on a percentage basis. Typically, this is done online or by calling the customer service department. Importantly, unlike regular (non-retirement) investment accounts, employer retirement accounts aren’t subject to taxes when you change your investment allocations. For this reason, I suggest reviewing your investments at least once a year to ensure you’re comfortable with how your retirement money is invested.
I hope this overview helps you make your retirement account investment decisions faster and with greater confidence. Remember - there’s a lot of jargon that the financial industry uses - I’m here to help you cut through the clutter and grow your wealth!