So you’ve signed up for your company’s 401(k) plan or opened an IRA for your retirement savings. Congrats! That’s a great first step.
But if you haven’t made your investment choices yet, you may still be behind the curve, whether that’s because your money was automatically allocated to your plan administrator’s default fund that doesn’t meet your individual needs — or it’s left in cash without any market exposure at all.
“Once you factor in inflation, you actually get a negative return from cash,” warns Ted Toal, a Certified Financial Planner™ at Rockwood Wealth Management in Annapolis, Md.
And yet nearly half of U.S. investors’ portfolios are in cash, according to a 2013 BlackRock investor survey, and more than a third of investors planned to increase their cash holdings over the following year. Even worse, more than 25% of investors think long-term money should be kept in cash investments, such as savings accounts or CDs, according to a 2013 Bankrate survey. (Need more on why that may be a bad idea? Read this.)
But even for those of us who know better, it can still seem overwhelming to pick your own investments — a feeling Rob Cucchiaro, a financial planner with Summit Wealth & Retirement Partners in Walnut Creek, Calif., attributes to decision paralysis.
“Studies have shown that the more options people have, the harder it is for them to make a decision, and that’s how people end up remaining in the default investment option,” Cucchiaro says.
Ready for some good news? When you’re armed with the right information, learning how to set up a retirement account may not be so difficult. “The most important step is the first one,” Cucchiaro says. “The sooner you start, the sooner the compound growth process can begin.”
Here’s what you should know to get started today.
How to Determine Which Investments You Can Choose
After you’ve set up your retirement account, your next task is to determine which investment options may be available to you.
If you’re enrolled in your employer’s 401(k) plan, your choices are usually limited — but diversified. A 401(k) account should generally include a variety of investments including U.S. and international stock funds and bond funds. (Click here to learn the difference between stocks, bonds and mutual funds.)
If you’ve opened an IRA, whether it’s a traditional IRA or a Roth IRA, you have many more choices, generally limited only by whether you’ve chosen a brokerage account or a mutual fund account. (The same is usually true if you open a SEP IRA, which is an IRA for the self-employed.)
If you choose to open your IRA as a brokerage account, you can typically invest in pretty much anything, including individual stocks — but be careful. “Even for a sophisticated investor, I’m against trying to pick and choose your own stocks,” Toal says. “You’re probably going to make some good picks, but the bad picks can offset the good. I’m for everyone using mutual funds, and specifically index funds.”
Why index funds? In putting together your retirement portfolio, it’s important to consider focusing on two major objectives: getting exposure to a broad diversification of particular asset classes (more on that in a minute) and avoiding high fees. (Even 1% fees can erode your returns by up to 30% over time.) Index funds—low-cost mutual funds—may provide both.
If you open your IRA as a mutual fund account on the other hand, you’ll generally be limited to that company’s mutual fund offerings. (In other words, if you open a mutual fund account at Vanguard, you’ll be choosing from Vanguard mutual funds.) But that’s not always a bad thing: Most mutual fund companies offer a well-diversified list of options.
One of the easiest approaches to choosing your retirement investments is to see what index funds are available to you — and in what categories. Usually you can access this information by logging into your 401(k) account (ask HR how to do this if you’re unsure) or your IRA or SEP account at the company where you opened it.
For a balanced portfolio, you’ll probably want to look at both international and domestic bonds, U.S. large-cap stocks, U.S. small-cap stocks, international stocks, emerging markets stocks and (if possible) some real estate investments. The right allocation to each of these investments depends on how long you have until retirement and your tolerance for risk in your portfolio.
This is called diversification — and it can be important. If you put all your investment eggs in one asset class, so to speak, you’re not protected if that particular asset class tanks. Also, the best performer among asset classes usually varies from year to year, Cucchiaro points out. In one year, it might be small growth stocks that gain the most ground; in another year, foreign stocks may outperform everything else. By diversifying your holdings, you can help ensure that even if one part of your portfolio doesn’t do well, you’ve got your thumb on something that’s faring better — and overall, hopefully, your portfolio will grow over time.
If your 401(k) doesn’t include an index fund for a particular category, Toal recommends considering choosing mutual funds with the lowest expense ratio — that is, the amount of money charged each year simply for being in the fund. “Over the long run, studies have shown that funds with the lowest expenses tend to have higher returns,” Toal says.
What About Target-Date Funds?
If you’re feeling hesitant to make your own investment decisions, a target-date fund may seem like a good fit, and it can be — because it does the work for you. This is a mutual fund based on your intended date of retirement that contains a diversified mix of investments, and it becomes more conservative as you get closer to your retirement date.
However, target-date funds aren’t always as straightforward as you may think. “I recently sat with one of my clients who had all of his money in a 2010 target-date fund,” Cucchiaro says. “He presumed that a 2010 target date fund was very conservative and was surprised to find out that it [contained] 50% stocks. I’m not saying that’s right or wrong. I’m just saying that it certainly was more aggressive than his expectations.”
The lesson? Just because the target date jibes with your retirement year doesn’t mean it’s a slam-dunk. Some fund managers have different ideas about what’s “conservative,” and the portfolio they put together may not be right for you.
So take a good look at the investment mix to make sure you understand what’s in the fund. (And if you need clarification? A financial planner can help explain it to you.)