How to Choose Investments in Your 401k or IRA

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Millions of workers have the opportunity to participate in a 401k retirement plan via their employer. Unfortunately, most people are not very well informed about stocks, bonds, mutual funds and ETF’s or how the Financial Services Industry works. The purpose of this article is provide enough information for the average investor to grow their retirement capital in the most efficient, safe and inexpensive way.

Like the majority of people these days, we all seem to be burning the candle from both ends trying to raise our children the best we can, manage our households and stay employed. It’s no wonder that the number of 401k and IRA investors actually spend very little time choosing how they invest their retirement money. I have seen all kinds of far out methods for how people choose their retirement investments, none of which are advisable and are pretty much guaranteed to rob you of thousands or tens of thousands of dollars that you would have had to pay for your needs when you are retired. Let me give a couple of examples.

Say hello to Scatter-Gun Sue. Scatter-Gun Sue has a 401k retirement plan sponsored by her employer. Her 401k plan offers her a total of seven investment choices, and since Susie doesn’t really know a lot about this stuff she decides to just evenly distribute her contributions to each of the seven choices. Hey, at least she’s diversified right? WRONG. Not only will she be way outside the realm of diversification, she will be losing much of her potential gains to the fees imposed by each investment.

Now let’s meet Company Man Chris. Chris works for a company that offers his company stock as an investment option in his 401k. Chris thinks his company is going to blow up big one day like Google or Microsoft so he puts 100% of his retirement money in his company stock. That must be a smart move since all his managers tell him what a great company they are and how they are all going to be rich one day. Besides, it worked for Google employees. But don’t forget the ones that it didn’t work for like Enron, Nortel, WAMU, Countrywide, Bear Stearns, Lehman, Merrill Lynch and the list goes on. You already get your income from your company and if you own a mutual fund you probably own your company stock as a portion of that fund. So if your company hits a bump in the road you don’t want to lose your current income and your retirement money. That is definitely not diversification.

You may have noticed that I keep mentioning diversification. Diversification is how you manage risk to your portfolio. The more diversified you are, the less risk you are taking. And since we are discussing retirement money, not discretionary money or fun money, then we want to take the minimum amount of risk necessary to grow our money at a rate that will beat inflation after fees, taxes and expenses. I will show you the best way to invest your retirement money that will give you diversification, the lowest fees and expenses and promise a return that few other investment vehicles can consistently beat.

Are you ready for the big secret? Well, I have to tell you upfront that this is not exciting or flashy. It does not require you to pay a broker or manager exorbitant fees. It does not involve derivatives, margins, credit default swaps, double shorting or any of that Wall Street jargon designed to make the average person believe they need to pay someone to manage their money. The big secret is index funds. Yep, plain old index funds. For starters, index funds are passively managed meaning there is no hot stock picker making millions of dollars from you the investors to try and beat the market. This allows index funds to have the lowest fees out there, less than 1/2 % with most. Fees really add up over the years as they eat away at the gains you made. Actively managed funds have fees from 1% up to 4%. So if your actively managed fund beat the market by 2% but you paid 3% in fees, then you actually trailed the market by 1%. Get it? The market is typically the S&P 500 Index or the Wilshire 5000 Index. These are the two benchmarks most stock funds attempt to beat, but rarely can. There will always be some fund out there that beats the market once in a while, but this is your retirement we are talking about. You want to match the market benchmarks consistently since no one can consistently beat the market.

I  highly encourage you to take another look at your 401k or IRA and invest your money this way. Invest in a stock index fund that attempts to mirror the S&P 500 Index or the Wilshire 5000 Index. Then invest a portion of your money in a Bond Index Fund. These two or three funds will mitigate your risk through diversification and offer the best consistent returns you will find at the absolute lowest cost to you. Take a look at Vanguard Funds; they invented the index fund back in the 1970’s and offer the lowest costs for index funds you will find for the average investor.

And for all you superstar day trader types, good luck. I would love for etrade, Schwab or Scottrade to show some data that demonstrates the average returns for day traders. I bet the majority are losing small fortunes paying all those commissions for each trade and trading way too often. Don’t get caught up in the drama on CNBC and Fox Business that leads you to buy stocks because some analyst says they are hot. Ever heard of Efficient Market Theory? This theory says that the prices of stocks and bonds take into account all available information. This means that whatever the current price of a stock is it has already adjusted to any news good or bad. So in order to beat the market you would need to get information no one else has about a stock and execute on that information before the stock price goes up or down. This would sometimes possible years ago, but with technology comes efficiency and the more efficient markets are, the harder it is for you to beat them. Oh, and that guy screaming buy, buy, buy on TV, the information he is giving to you has already been disseminated and the stock price already reflects it. So you don’t stand a chance picking individual stocks, you may as well go to Vegas.

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