In Part 1 of this series, hopefully I convinced you of how important it is to save for retirement. In Part 2, I talked about the different options that exist for retirement savings. In Part 3, I discussed how to efficiently prioritize the options that exist for your retirement savings. In Part 4, I discussed how and where you go to sign up for your 401K, 403B and IRA. In this final installment, Part 5 of this series, I discuss good investment options for your IRAs, 401Ks and 403Bs.
1) Determine the Appropriate Asset Allocation for Your Age and Risk Tolerance
Diversification is a powerful investment concept. It refers to saving your investments in different baskets. Diversification requires you to place your money in different investments with returns that are not completely moving in the same direction at the same times. When some of your investments are up, others will be down. To decrease your chances of getting clobbered at the same time, you must put your money in different investments such as stocks, bonds and cash. You can further diversify your investments by investing in domestic as well as international markets. The process of how you spread your money around and diversify is called “asset allocation”. The wise approach is to have more risk (equities) in your younger years and as you move into retirement move the majority of your money into less risky assets (bonds and cash). There are many different ways to allocate your assets for retirement, but below I outline one possibility.
Age: Less than 40 years
Allocation: 100 % in stocks. Of this, 40% invested in large cap-growth funds, 25% in small-cap growth funds, 25% in large-cap value funds, and 10% in international.
Age: 40 – 50 years
Allocation: 80 % in stocks and 20% in bonds. Of the stocks portion, 40% invested in large-cap growth funds, 25% small-cap growth funds, 25% large-cap value funds, and 10% in international.
Age: 51 – 55 years
Allocation: 70% in stocks and 30% in bonds. Of the stocks portion, 40% invested in large-cap growth funds, 25% small-cap growth funds, 25% in large cap value funds, and 10% in international.
Age: 55 – 60 years
Allocation: 50% in stocks and 50% in bonds. Of the bonds portion, 40% invested in large-cap growth funds, 10% small-cap growth funds, 40% in large cap value funds, and 10% international.
Age: 60 – 65 years
Allocation: Reduce stocks by 5% per year and increase bonds by 5% per year so that at retirement you have 25% in equities and 75% in fixed income. Of the equity portion, 40% invested in large-cap growth funds, 10% small-cap growth funds, 40% in large-cap value funds and 10% international.
2) Choose High Quality/Low Cost Funds
The second factor to take into account when you are choosing the mutual funds in your accounts is cost. Typically the lowest cost funds that one can buy are index funds. An index fund is a fund that merely tracks a specific financial market. For example an S&P 500 index fund just copies the movement of large cap stocks. A Russell 2000 index is used to track small cap companies. Index funds do not have managers making decisions about what to invest in so they are less expensive. They also tend to outperform actively managed, more expensive funds. So if these are an option within your plan, take advantage of them to carry out your asset allocation strategy.
If actively managed funds are your only option, invest in them but be wary of expenses associated with the fund. Actively managed funds have expense ratios and loads that eat into your returns. Minimize these costs as much as possible!
3) Rebalance Your Portfolio Annually
The great thing about investing for retirement is that once you are set up you really don’t have to do much. Just once a year look at your portfolio and make sure your investments still match up with the asset allocation you want. Because your investments grow at different rates, this can throw off your asset allocation. Make sure you rebalance it every year!
I hope you have enjoyed this 5 part series on Investing for Retirement. Please contact me with any questions or clarifications!
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