The great thing about index funds is that they are “set it and forget it” investments. But does that make sense for a retirement plan?
Absolutely, and for a number of reasons. First, though, you should understand what an index fund really does.
An index fund owns a selection of investments, much like a typical mutual fund. The difference is, nobody is picking and choosing those investments. There is no money manager in the background trying to pick winners out of a heap of stocks.
Rather, in an index fund you own the whole market, whatever market that fund is tracking. If it’s an S&P 500 index fund, you own the entire S&P 500 — all 500 stocks.
If the S&P 500 Index goes up, so does your fund. If it goes down, your fund falls too.
Likewise, you can buy an index fund that tracks the broad bond market, or foreign developed companies, or emerging markets stocks. Even foreign bonds and commodities.
The upside is cost. You get exposure to an entire asset class with no intermediary in the form of an active manager, so they are cheap and easy to hold. Since there’s little turnover in the fund, there’s almost no drag from buying and selling, no commissions and no real reason to sell it.
Unless you need to rebalance. That’s the “secret sauce” that helps you get an edge on just holding stocks alone. As some asset classes are challenged, usually other investments go up.
Rebalancing is simply programmatic selling of a portion of the winners you have in order to buy the relative “losers” in your portfolio. By taking gains automatically, you are able to bank those winning investments and get ahead of the general market curve.
That’s why index funds are so powerful in a long-term retirement plan. Automatic reinvesting and rebalancing, low cost management and minimized tax impacts keep money in your portfolio.
Index fund to win
More money in your portfolio allows you to compound more effectively and, in time, leads to a great return. It’s not about buying a stock fund and trying to sell it before a market decline.
Rather, index fund investing is about owning an asset class and prudently buying and selling parts of investments in a broader portfolio strategy at the lowest possible cost.
That’s risk management, and it’s something ordinary, everyday investors can do for themselves. The opposite — buying a small selection and stocks and sweating the ups and downs of the market — isn’t retirement investing at all.
In fact, that’s just speculation, the end result of which might be glory and might be pain. But it won’t be a retirement, that’s for sure.
You hear a lot of obscure terms in the investing business, too many of them math-related for sure. But one key idea that far too many gloss over is “portfolio.”
It sounds pretty complicated, but it’s not that hard to grasp. A portfolio is just a collection of investments. They are typically chosen at the same time with the purpose of providing the investor a range of asset classes.
This is not the same thing as diversification, which is owning a lot of investments in each asset class. An index fund with 500 stocks inside of it could be said to be diversified, but it’s not a portfolio.
After all, the entire fund is made up of one investment type — stocks. Now, stocks are great. You need them in your retirement plan to give you enough of a return to overcome inflation.
The problem with stocks is that sometimes they go down. That’s not a bad thing, generally. You get to buy more of them while they are “on sale.” But the ideal is to invest in a portfolio to balance out the ups and downs of the stock portion.
Traditionally, that means owning bonds. But a well-designed portfolio holds real estate, too, and commodities and foreign stocks and bonds.
As the market see-saws up and down, many times these other asset classes move in the opposite direction. That is, stocks go down but bonds go up. As U.S. equities dip, foreign shares enjoy a moment in the sun.
Often, different asset classes move contrary to one another. That’s a golden opportunity to rebalance. You don’t sell all of your stocks just because they are down. In fact, you don’t sell any.
Instead, you look for the asset class that has gone up and sell off a portion of that. Then you use that incoming cash to buy stocks while they are cheap.
A year later or so, you might find that the opposite is going on. Now bonds have slipped but stocks are riding high.
That’s right, you sell off some of the stocks and buy bonds. They’re on sale, after all.
In the end, the ultimate goal is to have a collection of stocks, bonds and other investments that gives you a stock-like performance without the stock-like volatility. Your portfolio return should even out to a regular, clockwork gain.
That way, the compounding effect kicks in and you get the best of both worlds: A strong, secure retirement from solid investments without the nail-biting stress of watching a collection of stocks get whipped around in a market downturn.
You probably have run into a few retirement books over the years. One of the more interesting of them was one entitled The Number.
That really puts a fine point on things, doesn’t it? How much do you need to retire, exactly? What’s your “number” for retirement?
Often, we assume a large round figure and let it go at that. Like $1 million.
But it’s more than a little unrealistic to pick a number from the air without knowing two important things: How do we get there, and do we even need that much money anyway?
Last things first. You should not target a number you need to retire but instead get a real sense of how much cash you need to live well and care for yourself. That’s what retirement is, after all — not having a job anymore.
Go through your monthly spending now. Look at your bills, your bank account, any credit card spending and come up with that number first. Work with a year’s worth, so you don’t miss any one-off costs like insurance bills or vacationing.
Now, subtract the costs that will go away. Probably, that will be your mortgage. You’ll replace cars less often, so halve your automobile spending.
Add back some money for healthcare costs, since those will creep up for sure. And make sure you assume a certain amount of “splurge spending” on travel or new hobbies.
Now you have your really important number, your cost of living in retirement. The only issue is how to pay for it.
Chances are, you haven’t really run your own Social Security estimates. Do it now. It’s free at the Social Security Administration.
Let’s say you came up with a figure like $25,000 a year in Social Security income. You know your post-work life is going to cost you about $50,000 to pull off.
Yes, you can retire
That means you need $25,000 in regular income. Assuming a 4% withdrawal rate, you now know you need $625,000 to retire. That’s a lot less than $1 million.
If you’ve been saving into a 401(k) plan for a few decades, even modestly, you might be closing in on your retirement number early! But let’s assume you are short.
No need to panic. Just amp up your savings rate and aim to work a few years more. The important thing to remember is that money compounds. If you can take Social Security and work part-time, your private savings plan has time to grow.
A retirement plan with $300,000 in it could double in value in 10 years if properly invested, and faster if you make larger contributions along the way. Making your retirement number appear is just willpower and planning.
It’s easy to understand how a retirement is built — steady saving, prudent investments and time. But so many of us fail at it because we get stuck trying to make just the first moves.
As the saying goes, “A journey of a thousand miles begins with a single step” and that’s true. You really have to set aside the first dollar somewhere, somehow, with the intention of not spending it but instead growing it over years.
Here are five steps you can take to make a plan start off right and, in time, turn into a real retirement that will fund your golden years.
Ready to build a retirement? Here we go:
1. Save at least something, now
You need at least some ready cash for emergencies. Aim for a low, achievable number, say, $50 out of your next paycheck. Stick it into a savings account. Next paycheck do another $50. Pretty soon you’re sitting on $1,000 or more. It won’t take long.
2. Ramp it up automatically
Once you have a month or two in expenses sitting in savings, open an individual retirement account (IRA) at your bank and fund it. Likewise, join your workplace 401(k) if you have one.
If you’re already putting away $50 in cash for your rainy day fund, put the same into your retirement plan. Definitely ask about your company’s matching policy. Try to set aside at least enough to get the full match, and ask if your employer will bank future raises automatically, too.
3. Invest windfalls
Got a tax refund? A gift from a relative? Picked up some fast cash on an odd job? Our natural inclination is to treat found money as a chance to spend. In fact, you should treat is as money that doesn’t exist today. If you invest it, it will compound, turning into much more money down the road.
4. Cut taxes, now and later
Saving into an IRA or 401(k) will lower your taxes today. That’s exactly the kind of “found money” that helps a retirement balance grow more quickly. What you don’t pay in taxes should allow you to save that much more.
If you use a Roth IRA, you get to avoid taxes later, when you take money out. It grows tax-free in the meantime, too. It’s a win-win for retirement savers.
5. Keep investing costs low
It’s hard for people to believe, but using expensive, actively managed mutual funds is a real drag on your retirement. The pitch from the funds is that superior management easily beats the stock market averages.
The data, however, suggests a far different result: After fees, the majority of active funds cannot beat the market averages consistently enough to matter. Meanwhile, those fees cost you real money, now and into the future.
Taking a few small steps toward your retirement may not feel like doing much. But, over time, making the right moves early will help you grow your savings into plenty enough money to retire well and on time.
It’s a basic truth about us as human beings. Most of us don’t want to think about money at all. And that costs us money in the long run.
Data from Cerulli Associates puts a number on it — 38 million. That’s the number of stranded workplace retirement plans there were in the United States in 2009. A few years later, in 2012, a government study found that just half of 1% of plans owned by former employees was moved to new employers.
Half of 1% is a very low figure. If 1,000 people change jobs, that means just five of them take their money in 401(k) plans and roll that money over into new plans. And 995 simply leave money behind.
When you consider that the average 401(k) balance is around $100,000, that’s a real surprise. Maybe some of those folks truly believe their previous employer is a fine steward of their retirement.
In some cases, too, a large portion of those balances might be tied up in the former employer’s stock, so the worker believes, incorrectly, that it cannot be sold. In any case, money is set adrift and, too often, forgotten about nearly completely.
The cost of that lack of personal stewardship is enormous. The typical 401(k) plan charges very high fees, upwards of 2% and in some cases almost 3%. Think about for a minute: If the market returns 7% in a year, that same account leaks out 3% of its total balance in plan fees.
If the account is worth the average 401(k) balance, that means it has grown by $7,000 in market gains but lost $3,210 in fees. The money managers made off with 46% of your retirement earnings in a single year!
And that continues, year in and year out. It’s nearly criminal. Now multiply that by 38 million and you start to get a sense of what a racket the 401(k) industry really is.
You can turn this number around, but it means taking action. First, you have to find your old 401(k) money. It may be managed by the same broker but very likely it has changed hands at least once.
Call up human resources at your former job or jobs and find out. Then contact the managers and figure out how to access your old accounts.
Never leave money
Now, get down to the bank or go online an open a rollover IRA account in your own name. Once that is set up, ask the 401(k) plan for rollover instructions or ask your new IRA provider to start the rollover process.
The problem now is managing it. Thankfully, you can easily build a very low-cost, effective and above all cheap retirement portfolio using simple online software. Your fees, instead of being a punitive 2% or 3%, could be a flat annual dollar amount that doesn’t amount to the cost of good running shoes for the whole year.
Don’t leave money stranded at your old jobs. You’ll need it later to retire. Not thinking about it is no excuse, and the cost of not thinking is enormous.
We are, without a doubt, the most highly trained consumers in the history of the world. Sure, people have been buying and selling for centuries, but how many cultures before us had it down to such a science?
Stores line up candy at eye level, drop subtle lighting hints on new shoes and jewelry, give us every reason to buy now, not later, whatever the category or need. Courses on retail are taught in our colleges, while companies spend millions mocking up shopping aisles in order to test out new ideas.
Investing is no different and never has been. Stock brokers have long been trained to sell what’s known as a “story stock,” that is, a company with a tale behind it. People are drawn to the idea of a superstar CEO, an amazing new product or a fundamental shift that creates an opportunity.
We love stories. They help us understand the world. A conflict must be introduced and resolved, with a beginning, middle and end, and a moral is usually attached that ties things up with a neat bow.
Yet the real economy is far more quixotic and humbling. Products are introduced too early or too late. Perfectly good companies are crushed out of existence. Perfectly bad companies stay around for decades, inexplicably surviving.
Great managers fail to save the day. Stocks that should go down instead go up and vice versa. Meanwhile, incredibly boring companies — firms with truly no story to share and no uplift in their mission — they just grind on, growing and paying dividends.
When we buy individual stocks, two things can happen. We can ignore them or pay attention to them. They will perform to expectations (or they will not) regardless of how much we personally care about the story behind it all.
Yet what drives that initial impulse to buy is often the story, the hot “tip” we get from a friend, the idea that we have the inside track on something big.
In the end, if you buy, say, 50 individual stocks, you are likely to make money on some of them and lose money on others. Some will pay dividends and some will cut their dividends.
And the lot of them are likely to grow their earnings at a rate that is somewhere north of the inflation rate, once you count reinvested dividends.
Stock market stories
Once you accept that, there’s no reason to buy 10 or 20 or 50 stocks when you can diversify dramatically by owning hundreds or thousands of them in an index fund. You still get that earning growth and dividend inflows, but your individual “story stock” risk goes away.
Because you didn’t impulse buy, you are far less likely to impulse sell, too. And so the growth engine rolls on, year after year, with no worries at all.
Investing could not be any easier than that. If you want a good story, go to the movies or get a book from the library. If it doesn’t end the way you like, you can always see the next show.
A lot of small investors spend a lot of time — far too much — worrying about their investments. They buy concentrated positions in a few shining stars and then hope.
What happens next is all too predictable. One position rises and they pat themselves on the back. Another one falls and they grumble and blame “the market” or some equally nefarious force in the background.
What they never do is blame themselves. No matter how bad the pick turns out to be, any losses must be attributed to the actions of others and never the stock picker.
Then, a familiar pattern appears. Fearful of taking more losses, the investor begins to focus on the losers in the bunch. For a while, the winners offset the losers. Then the paper losses mount and the pressure is on.
Just when things are at their worst — the whole portfolio is negative for the year! — the investor decides to cut his or her losses. The dog gets sold.
Naturally, many of those supposed “loser” stocks soon spring back. The winner stocks of last quarter lose steam, too. The portfolio looks quite different only a few weeks later.
And on it goes, failing to sell a gainer while it’s high enough to warrant it, then failing to hold on to supposed losers until the loss is so bad it must be realized immediately.
The solution, the research shows, is to depersonalize the whole matter. Why pick stocks at all when you can own the whole market?
What the numbers show us that “time in the market” trumps “timing the market” year in and year out. Rather than renting stocks for a short period of hoping for a pop, you own them for years.
Why time in the market works
Over those years, the dividends pour in at about 2% a year. That money is reinvested automatically. Likewise, earnings growth is steady over the long run, about 5%. This translates into steady appreciation across the whole market.
And, just like that, you compound your money, year in an year out, just by buying and holding stocks. Add that to a portfolio of foreign stocks, bonds, commodities and real estate and you’ll likely do a bit better.
Rebalance steadily as you go and you avoid the worst of the excessive, scary highs and the depressing lows, which can happen and will happen over the years.
Time in the market works because it forces you to ignore your dangerous emotions. We love the idea of winner stocks and want to own them forever. We hate the idea of losing money and will do anything to stop that pain.
The fact is you will experience both emotions. A disciplined portfolio keep us from overreacting and hurting the long-term positive return we all need to retire well.
You’ve probably heard or read about all kinds of strategies that will make you rich investing. They go by many names, but they all follow the same basic idea: Zigging when others zag.
It might be buying sectors at certain points of the business cycle. Or stocks that have been bid down to unusual lows. Or only owning stocks ahead of elections, when Congress is out of session or the moon is full.
Yet any kind of market timing or stock selection strategy depends on the same basic mechanism to work out. You have to know something that others don’t.
If you’re talking about a tiny microcap, it’s possible you know something absolutely nobody knows. Not likely. Just possible.
It’s also possible that anyone in the world with deep enough pockets will bet against your position for any reason or no reason, wiping out your investment in seconds.
If you’re looking at a large, publicly traded company, you might have an inkling that management will move one way or another on an opportunity. But the chances you’re the only one taking that bet are few. And plenty of deep pockets could invest against you.
Or you could take advantage of the only free lunch in investing — rebalancing.
Rebalancing does not depend on factors beyond your control. It simply recognizes reality and reacts accordingly. Your decision to buy or sell an investment rests solely on the fact that it has risen to a value and now represents a larger portion of your total portfolio than intended (so you sell some of it).
Or that it has fallen and is now a smaller portion of your portfolio than intended (so you buy).
Here’s the neat thing: You can buy using incoming cash from contributions, of course, but also incoming dividends and interest. If you sell and generate cash, that money has a home elsewhere in your portfolio, even if nothing has gone down.
Get your free lunch
Since something went up (what you sold), that means something else is relatively less in your total portfolio. That’s what you buy with the cash.
Do this over and over and you can’t help but sell high and buy low, efficiently and at a low cost. That’s how your portfolio grows steadily and compounds into a powerful, effective retirement plan.
You aren’t tempted by stories of winner stocks that end up being dogs. You aren’t worried when some part of the market falls. To you, it’s an opportunity. In fact, the only “danger” left is cost.
Cost is the killer, and you can manage that by using inexpensive index-style ETFs. The only free lunch in investing can be had without a lot of tricky trades, costly advisors and complex research.
All it takes is zigging when they zag, the right way.
Investing for the long term means you should own a portfolio of stocks, bonds and other types of investments. But why, and what is a portfolio, really?
First, let’s consider some of the common investments chosen by people who use a 401(k) plan at work. Many of them by default are put into mutual funds. That’s a kind of portfolio, but usually a portfolio of stocks and only stocks.
Increasingly, too, people are being placed by default into target-date funds. These are collections of mutual funds that cover a variety of asset classes, such as stocks, bonds, foreign investments and real estate, and then rebalance them.
A target-date fund is supposed to lower your risk over time by increasing the proportion of less-volatile investments.
Of course, volatility and risk are not synonyms, nor is it true that the target date you might choose for retirement is the best fit for your circumstance. But that’s where people end up.
Another way that some people are invested in workplace plans is cash, or a cash equivalent such as a money market fund.
This isn’t investing at all. It’s just saving, and usually high-cost saving, since you have to pay the plan administrator a fee and inflation is weakening the purchasing power of your money steadily over the years.
Finally, a lot of people in workplace plans are given or have a chance to buy their own company’s stock, usually at a discount. The problem here is the risk of concentration. Owning a lot of one stock is a huge risk. The fact that it’s your employer does nothing to reduce that risk.
What’s the answer? Own a real portfolio, and own it as cheaply as possible using index funds. A true portfolio will hold thousands of stocks and bonds, greatly reducing concentration risk.
It also will be diversified into a broad variety of asset classes, including the kinds of investments you find in target-date funds. However, instead of mechanically moving toward a distant date, a great portfolio is adjusted to match your personal goals and will change dynamically over time to match the material events in your life.
Understanding what is a portfolio
Finally, you will own no cash at all, or hardly any. A real portfolio rebalances periodically, investing incoming contributions and cash from dividends and interest payments as they come in.
In the end, you shouldn’t be able to say “I own that stock” or, to the contrary, “I’m in cash now.” Rather, you should be saying “I own stocks, and that means I own nearly all stocks” through an index fund and “My cash is working for me, all the time” since you stay in the market through thick and thin.
Risk is adjusted by reviewing your personal tolerance for the ups and downs — volatility — and in the context of when you actually might need your money for living expenses in retirement, whatever year that turns out to be.
One of the longstanding idiosyncrasies of stock market investing is patterns. Human beings are keen on finding them, often where they don’t exist.
Scientists even have a word for it: “apophenia.” It means seeing connections and patterns that aren’t meaningful, and we all fall victim to it.
The crackpot version of our tendency to see patterns is the conspiracy theory. Odd lights flash in the sky and we imagine aliens are among us. People become transfixed by famous murders and ascribe motives to strangers in the background of random media images.
But we all do it, and especially stock market traders. Right about this time of the year you are likely to see headlines about how you should “Sell in May and Go Away.” This is a version of what’s also called the Halloween Indicator.
In short, some traders believe that we should get out of stocks entirely in May or, failing that, by June (thus the “June swoon” when hangers-on finally give up and sell). Then, it is supposed, we should all buy back in by October.
The point is to own stocks in winter and not in summer. The strategy’s proponents contend that the idea continues to work, while most economists and academics dismiss it as folk wisdom or pattern-seeking.
The funny thing is, the more people think it’s there, the more likely it is to be there for real. Fearing that they might miss a chance to market-time profitably (for once), the Halloween Indicator can become a self-fulfilling prophecy.
Naturally, selling all of your stocks and going to cash is very costly, and not just because of commissions. In fact, you are likely to miss a lot of months of appreciation and dividend income, money that could and should be growing your portfolio through compounding.
Likewise, if you hold stocks all through the winter, you are just as likely to see a downturn that will test your belief in any kind of market timing theory and could lead you to panic and sell for no good reason at all.
A far better approach is to own a portfolio of stocks, bonds, real estate, foreign stocks and bonds and commodities and to rebalance them. That way, you only sell when there is a good reason and you buy with good reason, too.
You can keep your costs minimized by using inexpensive exchange-traded funds instead of specific stocks or bonds, and the results are incontestable. Burton Malkiel, the author of the investment classic A Random Walk Down Wall Street, maintains that just rebalancing stocks and bonds over the past 15 years earned a 1.5% premium over the straight stock market.
That’s real money and a real return that could be had year-in and year-out and absolutely won’t be made by the folks sitting on uninvested cash all summer every year.
If you think you have a stomach for watching stocks rise in the summer while you are out of the market and then fall in the winter while you are in and you can afford that kind of emotional risk every single year, then “sell in May” might be for you.
But the surer path to retirement is buying your investments once and then rebalancing as need be, no timing necessary.