Sunday, July 31, 2011

Putting your money to work

In the second post of a series on getting your money to make its own money, we'll chat about making the most of the options in your 401(k). In the last part of the series, we discussed the various tax-sheltered accounts the government has provided to allow us to more efficiently save for retirement. These accounts basically consist of the 401(k) and the IRA. With most decent jobs an employee is offered a 401(k) and (hopefully) a company match to contributions by the employee. While the tax benefits of investing in a 401(k) can be huge, the next most important thing (and perhaps just as important) is what exactly your money is invested in inside the account.

Most of these accounts provide mutual funds that allow one to invest in stocks, bonds, and real estate. A mutual fund is a vehicle by which people can contribute a small amount of money and still be involved in a number of investments (i.e., be diversified), since the people in the fund are essentially pooling their money. The important part to remember when evaluating the funds in your 401(k) is that the companies providing (and managing) the funds to your employer often charge them exorbitant fees to do so. The trick is to find those funds with the least onerous fees. Rather than past returns, manager tenure, or trading strategy, the number one determinant as to future fund performance is the amount of fees it charges. In contrast to just about everything else in life, when investing, you get what you don't pay for. To explain it simply, no one knows where the market will be one month from now, so we should invest accordingly. The type of mutual fund that lives according to this mantra is what's called the index fund. What it does is, instead of employing a hot shot manager to pick stocks and beat the market, it humbly buys every stock in a certain index (such as the S&P 500) and holds them. As you might imagine, this strategy is quite inexpensive to implement, and thus it results in mutual fund fees that are much lower than those that try to beat the market (i.e., actively managed funds).

A mutual fund's fees are noted in the fund's expense ratio, and this is what one should focus on, as it will likely be one of the easiest and most important wealth building steps you can take. If you can obtain the packet your company provides regarding benefits, check what your 401(k) is currently invested in (or what options there are). Google the name of the fund(s) and try to find its ticker symbol; this is the 5 letter short name for the fund. Then go to and type the ticker in the "quote" box at the top. For example, google "vanguard target retirement 2045." You'll see the VTIVX symbol in the first couple of google entries. Now, typing that into morningstar's quote box, we'll see the mutual fund's profile. In the second set of tabs, click on expenses and you'll notice that this fund has a 0.19% expense ratio. This is very good; compare this with what you find for your funds.

To keep your investing simple, diversified, and appropriately risky, it's a wise move to select the "target retirement" or "lifecycle" fund in your 401(k). These funds automatically grow more conservative as one approaches retirement. Choose the one closest to your estimated year of retirement (such as 2045). If your fund is nowhere near as low as the Vanguard fund mentioned above, you may have an shoddy 401(k). This is, sadly, more common that it should be, and it costs you big money in the long run. See the adjacent figure, which shows the impact of a high expense ratio over the long run. In this example, a fund in my girlfriend's 401(k), the American 2045 fund (with an expense ratio of closer to 1%), is compared to the Vanguard fund mentioned above. We imagine you start with $50,000, and you're investing for 30 years, say, till you're 65 (and the market returns 10% per year). You'll notice on
the right of the figure that the Vanguard fund, because of its low expenses, provides you with over $200k more at the end of the time period (that's ~32% more!). All for no extra effort on your part. And this doesn't even consider any extra additions over those 30 years. If the fees in your 401(k) are nowhere close to those of Vanguard, lobby your HR person (or boss) for some better options. They'll likely thank you in the long run, as they're probably investors too.

To check the impact of your particular fund's fees, check out the Vanguard cost compare tool, with which the above figure was made.

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