I recently started reading “The Paradox of Choice” by Barry Schwartz. It discusses when we are asked the question “Would you like the freedom to choose X?”, we almost always without hesitation respond in the affirmative. However, we never take into account the negative affect of accepting choice in nearly every aspect of our lives. Making decisions takes effort, and if we have to decide on the majority of actions throughout our day, we are going to become stressed out.
Let’s look at one area where too much choice can be viewed as hazardous to our financial health – investing for retirement. There are several items to consider when investing for retirement:
- Which type of account should I use? – We have the 401k/403b, Roth 401k, Roth IRA, Traditional IRA and after-tax brokerage accounts.
- What should I invest in? – We have stocks, bonds, mutual funds (index and actively managed), ETFs, options, REITs and this is just the start. There are many other instruments for advanced investors that are beyond the scope of this article.
- How should I allocate my money? – Taking into account the first two factors, you can see there are well over 100 ways to allocate your money.
There are other questions to ask, but they have much simpler answers:
- When should I start investing? – Yesterday, but since that’s not possible, right now.
- How much should I invest? – As much as you can afford.
I am going to provide you with a simple plan that will get you on the track to a secure retirement. First, let’s address the types of accounts:
401k/403b – This is where you should start investing. Most employers will match your contributions up to a certain percentage, let’s say 3%. So, if you contribute 3%, they will contribute 3%, thereby making your contribution 6%. You just doubled your contribution with no additional effort! You’ll have to review the details of your employer’s plan, but some level of matching contributions is the norm. You can contribute up to $17,500 to a 401k in 2013. We’ll come back to this limit in a minute. All you have to do for Step 1 is invest enough in your 401k to get the full employer match.
Roth IRA – This is a beautiful thing. You invest your money after taxes have been paid and your investments grow tax and when it is time to take the money out (after you are 59 1/2), it is tax-free! You can contribute up to $5,500 to a Roth IRA in 2013 (subject to income limits). After you have completed Step 1, you should invest as much as you can in a Roth IRA.
401k/403b – If you have completed Steps 1 and 2, you should now go back and contribute your additional money to the 401k up to the limit if possible.
Brokerage (after-tax) – If you have additional money to invest (lucky you!) you should invest it after-tax brokerage accounts. This will give you flexibility if you need to withdraw funds before retirement because there are no restrictions on when you can take money out of your brokerage account. You’ll just have to pay capital gains taxes on the proceeds.
Now that we’ve covered how to allocate your money across accounts, let’s talk about what you should purchase with your investment funds. Unless you are Warren Buffett or you want to spend a large portion of your free time researching companies, you should be investing in index funds. Index funds seek to track the performance of a segment of the stock market. For example, there are several index funds that track the S&P 500. All mutual funds charge a fee, called an expense ratio, to investors. Your goal should be to minimize the expense ratio of any funds in which you invest. Index funds typically have expense ratios less than 0.25%, with some as low as 0.05%. Mutual funds that are actively managed, by a “financial expert”, typically have expense ratios greater than 1%. Since you cannot predict which experts will do the best job of picking winners, the single greatest predictor of future returns is the expense ratio, and smaller is definitely better.
I am going to give you a simple asset allocation that has worked very well for me and is extremely easy to maintain. I prefer working with Vanguard because they tend to have the lowest fees and are actually owned by the customers that invest int their funds. I will suggest 3 specific funds that you can use to achieve the target allocation:
- 50% US Stock Market – Vanguard Total Stock Market Index Fund
- 30% International Stock Market – Vanguard Total International Stock Index Fund
- 20% US Bond Market – Vanguard Total Bond Market Index Fund
If you have been delaying investing because you are overwhelmed by the available options, this plan is a great place to start. Remember, the earlier you start, the more you’ll benefit from the magic of compounding. I prefer a very simple investing strategy because it reduces my stress and allows me avoid making rash decisions based mainly on emotions – “the sky is falling!”. As with any investing strategy, there will be ups and downs, just stay the course.
If you are living beneath your means, you’re already in a fantastic position. Implementing a sound investment strategy will simply create a more comfortable cushion and allow you to sleep better at night. I know it does for me.