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When you go to select your investments within your 401(k), other retirement account, or miscellaneous investments, how do you know what investments you're choosing? Remember, a 401(k) or Roth IRA is simply a tax designation for an investment. The tax treatment matters greatly, but so does what you choose to invest in within it.
HAVING A BASIC UNDERSTANDING OF YOUR INVESTMENT SELECTIONS WILL EMPOWER YOU TO MAKE BETTER CHOICES.
Let's review a few basic investments types:
1. ACTIVELY MANAGED MUTUAL FUNDS
- When you select a mutual fund to put your money in, you are selecting a group of stocks and/or bonds. What stocks and/or bonds are in each mutual fund have been selected by a professional who is actively managing the fund - or in other words buying and selling assets he or she thinks will maximize your dividends.
2. INDEX FUNDS
- When you select an index fund to invest in, you are again selecting a group of stocks and/or bonds. The major difference lies in the fact that these funds are not actively managed and have low fund turnover. Thus, they have lower expenses associated with holding them.
Although it intuitively seems that actively managed funds would consistently out perform index funds, analysis have shown that this is only rarely true over a long investing period (like 20 years).
Factors to consider when choosing funds:
1. EXPENSE RATIOS
- Owning any of these funds costs money, which can be reviewed by looking at the expense ratio. Index funds have significantly lower expense ratios than mutual funds because they are not actively managed. You cannot underestimate the amount that fees will eat into your nest egg over decades. As an example, let's say you invested 10K in a fund yielding a 10% return and left it for 40 years. In an index fund (expense ratio 0.04%), your final value is $446,056. In an actively managed mutual fund (expense ratio 2%), your final investment value is only $217,245.
2. STOCK TO BOND RATIOS OF YOUR OVERALL PORTFOLIO
- Bonds tend to protect your portfolio in a deflationary period, but they often don't carry the potential for as high of returns as stocks do. If you're young and don't plan to retire soon, many advocate a 70/30 or 80/20 stock to bond ratio for your overall portfolio. John Bogle, founder of Vanguard, says you should "own your age in bonds."
3. PRIOR FUND RETURNS?
-Remember, past performance isn't predictive of future performance in the marketplace. There has been a lot of research done in the financial world on this topic that has been consistent in results. The strongest predictor of a fund's future returns is not its previous returns, but its expense ratio.
There are more factors to consider, like your risk tolerance, how long you plan to hold the investment, and taxes - but a little bit of basic knowledge is a great place to start. Take a look at your retirement accounts today and make sure you have optimized your selections!
For more information, check out the book The Simple Path to Wealth by JL Collins or The Bogleheads' Guide to Investing.
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