Retirement Investing 101

Investing for retirement is a daunting topic for many.  Stocks, bonds, ETF’s, REIT’s, when to buy, when to sell, and dozens of other topics can make growing your nest egg seem like an impossible headache.

But there are a few basic steps you can take to easily put money away for the future.

 

Set Up Automatic Investments

The single most important part of investing is regularly putting money aside.  The best way to do this is to set up automatic transfers that move money into your investment accounts every pay period.

Some people complain that they don’t have any extra money to set aside.  If this is true, just start with a very low amount – automatically transfer $20 on the 1st and 15th of every month.  Once you get used to living with this money invested, slowly step it up to $30 every 1st and 15th, then $40 every 1st and 15th, etc.

 

What Account Type?

When saving for retirement, the U.S. government has given consumers a few great account types to put their money into.  Both 401(k) accounts and IRA accounts are where your retirement savings should be going.

These retirement accounts let your money grow without paying taxes on the earnings until you withdraw the money.  This means if you get a cash dividend from some of your funds, or if you sell some of your investments for a profit, you don’t pay any taxes on the earnings.  This tax-saving adds up to a huge amount over the years.

If your company offers a 401(k) account, this is a perfect place to start.  If not, look at opening a Traditional IRA or Roth IRA account.  If you are lucky enough that your company offers a contribution match, donating to a 401(k) is even more of a no-brainer, as they’re giving you free money just for investing in your future.

 

When to Buy and Sell?

Many people try and time their buying and selling of funds with stock market swings or anticipation of these swings.  Simply put, this is a horrible idea.

It is impossible for you to correctly predict market swings over a long period of time.  You are far more likely to mis-time something and hurt your investment.

This problem is compounded by the fact that many trades cost fees to execute, which eat into your earnings.  There are also much higher taxes associated with short-term trading which will give more of your earnings to Uncle Sam.

The only viable strategy is to buy funds over time and hold on to them for as long as possible.  This will minimize trading fees and taxes, and avoid the temptation to try and time the markets.

 

What to Buy?

The part of investing that typically trips most people up is what funds to buy.  People try to pick individual stocks, or wade through the thousands of mutual funds (collections of many stocks) available and try to guess a winner.  Both of these are fruitless exercises.

For individual stocks, you have no idea what stocks are good buys and what are bad buys.  You don’t know what a company’s future entails better than the myriad of finance people who choose stocks for a living.  Plus, buying individual stocks will not sufficiently diversify your portfolio.

Choosing a mutual fund is no easier task.  Although there are a slew of organizations to rate the quality of past performance of each mutual fund, it has been shown that past performance is no indicator of future gains.  Many mutual funds who were top performers in one decade are terrible the next decade.  Further, most mutual funds carry heavy operating fees that substantially eat into your earnings.

Luckily, something called index funds are your answer.

Index funds are tied to a computer model, and don’t rely on having a person (fund manager) actively buy and sell stocks that make up the fund.  This means index funds have incredibly low costs.  Most index funds cost 0.3% a year or less.  The average mutual fund charges you 1.3% a year.  Mutual funds cost over 400% what an index fund costs!

But you get what you pay for, right?  Mutual funds must outperform index funds?  Wrong.  There have been several studies that have compared performance, and a basic index fund (the S&P 500) outperforms 2/3rds of all mutual funds.

So then the only question is, which index fund to invest in?  There are three types of index funds typically recommended:

1. Total stock market funds.  These funds invest in every stock in the U.S. stock market, giving you diversification in over 3,500 stocks.  Vanguard Total Stock Market Index Fund is an excellent example of this type of fund.
2. Small-cap growth funds.  These funds focus on smaller companies with more possibility for growth.  They also carry more risk, but in the long-term they often outperform other categories of funds.  It’s wise to buy these funds if you plan to hold on to them for a while.  Vanguard Small-Cap Growth Index Fund is a great example.
3. Total international stock market funds.  These focus on all international markets, both developed and emerging, and give you good diversification by including non-U.S. funds in your portfolio.  Vanguard Total International Stock Index Fund is a solid example.

Depending on your age (and therefore appetite for risk), you can adjust how much of each fund type to buy.  A good mix is 50% total stock market, 30% small-cap growth, and 20% total international.

 

Final Formula

So in the end, it’s not so tricky.  Set up regular investments to your 401(k) or IRA account, buy a few different types of index funds, and hold on to them for as long as you can.

That’s it!  You just learned 95% of what you need to know about retirement investing.  Now sit back, live your life, and watch your nest egg grow.