401K/403B Mutual Fun(d) Decisions: Part 2, Fund Allocations

*My apologies for the brevity of this post. I’m feeling terribly under the weather (thanks, DC, for being 80 degrees one day and 40 the next). More on this topic to come.

Now that we’ve gotten what fees and expenses to look for out of the way, it’s time to talk actual funds. Please note again that I am not an investment professional (yet!) and can only educate on the types of funds out there. I’m not selling funds until I get some commission. ;)

For starters, you already know about equity (or, stock) funds and bond funds. (More on bonds in a future post.) Depending on the financial advisor, advice will range from “go 100% equity” for young people to “keep it 50/50 stocks/bonds.” As stated in previous posts, your choice depends on your risk tolerance, but know that risk aversion, or a very high allocations to bonds, can lower your returns potential over time.

That said, look for stock funds that have the broadest range of stocks possible, like an index fund that reflects the S&P 500 or Wilshire 5000. If you find an index fund that has every stock available (more than 5,000), go for it, for maximum equity diversification.

Next, throw in a good mix of U.S. Treasury, and maybe corporate, bonds. The longer the maturity, or length of time until you get the principal amount back, the higher the yield, to compensate you for the risk you’ve taken of giving your money to the government for such a long time (the longest maturity available for U.S. Treasury bonds is 30 years). 

Don’t forget international stocks and bonds! They provide great diversification to a U.S. investor’s portfolio. 

I recommend finding index funds for all of these asset classes. If you have to go with an actively managed fund (as you would have to do for bond funds), go with one with low fees and high ratings on Morningstar.com, a well-respected finance research website.

401K/403B Mutual Fun(d) Decisions: Part 1, Expenses

Anyone my age or younger will probably never know what a corporate pension looks like. And, sadly, Social Security will have likely run out by the time we retire. So, saving for retirement is a burden we bare all to ourselves. Employers try to help by offering 401Ks or 403Bs, but this gets overwhelming when there are typically approximately 80,000,000,000 mutual funds and ETFs to choose from.

How do you know a good fund from a bad one?
What the hell is the difference between a "core value" fund and a "large cap blend" fund, anyway?
Should you go for gold, just because a metals and mining fund is available?

Don't pull your hair out over your 401K. Remember that it's there to help you. Over the next couple of posts, we'll talk through some high-level details to consider when selecting funds for your portfolio.

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One of the biggest things to keep in mind are fees and expenses. These dollars can set the best of funds apart from the worst because of simple math: the more you pay in fees, the more your investment has to return to make up for those fees. God only knows that you don't want to just go around giving your money away for free. So, here are some brief explanations of the fees you'd typically see from mutual funds.

Mutual funds will typically have 4 types of expenses: operating expenses, a front-end load, a back-end load, and a 12b-1 fee.

Operating Expenses
Operating expenses are costs necessary to run the fund. Fund managers have to pay electricity bills like the rest of us, plus employee salaries. Operating expenses are generally hard to get around because they're just a part of doing business.

These fees can be as low as .06% (also known as 6 basis points) of invested assets and as high as 1.5% or greater. Index funds generally have the lower fees, as it doesn't take as much work on the part of the fund manager to run the fund, since it is supposed to just be a reflection of an existing stock or bond index. You might also see this style of investing called passive management. It's sister, active management, is much more expensive. Actively managed funds are typically trying to outperform the overall market or a certain index by investing in specific stocks. In order to do that, fund managers are much more involved in the fund, handpicking stocks or bonds. As a result, these funds wind up being much more expensive; unfortunately, they don't always meet their goal of beating the market, either, meaning that investors are charged more for worse performance, potentially. 

My advice to you is to go for a passive index fund that will reflect an index like the S&P 500, or even better, every stock in the market (more on that next week) for lower expenses.

Loads
Now, the front- and/or back-end loads, on the other hand, are not so necessary. A "load" is basically a sales fee charged to you when you first buy the mutual fund ("front-end" load) or when you sell, or redeem it ("back-end" load). Then there are no-load funds, mostly from a company called Vanguard, which is extremely well respected in the finance community.

These expenses can run from 0% to 8.5%. The load is especially important to note because it can be total robbery of your investment. When you pay a load, especially a front-end load, you really are just giving your money to a fund manager and not asking for it back. You do expect for the return on your investment to be greater than the load, but you've put yourself farther in the hole from the start.

Example from my own life (glad I learned these things the hard way, so you don't have to!). When I switched jobs to my last job before business school, I rolled over my previous 401K into an IRA (we'll talk about those later, too). I was curious about active management, so my retirement advisor at my bank recommended that I go with a Goldman Sachs fund that had a 5.25% load. I started with about $4,000. After the load, I was only investing $3,800. I needed the fund to return me my $200 (AT LEAST), plus the 1.25% annual expense.

Let's just say, after the market spun itself around in 2010 and 2011, I was lucky to finish right back where I "started," with $3,800. I could have lost much more. But had I invested in an index fund that reflected the S&P 500 with a no-load fund, I would have gained about 15% over that same time period. You live and learn.

12b-1 Fees
12b-1 fees are optional fees the fund can charge so investors pay for part of the fund's advertising costs. Funds do charge them, but again, if there's no need to just give your money away and dig yourself further into a hole, don't do it.

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So, now you know some the key expenses to look for when selecting a mutual fund. (Remember to go cheap!) Next week, we'll look at some of the types of funds that will help you diversify and grow your retirement savings.

Can you risk it?

My great aunt had a way with words. Among her best quotes are, "Love is good, but money's better," "Love don't pay the rent," and "Don't marry a man if he don't have a key to something." (Great advice on all fronts.) Once, my sister told her about a guy she'd started dating, and my aunt wanted know if the guy was trustworthy. Instead of asking, "Do you trust him?," she said, "Can you risk him?"

She wasn't all wrong in correlating risk and trust. It's hard to trust the market, since you know it flucurates so much, so it all comes down to how much you stomach.

The first thing to know and remember like your own name is that there is no such thing as a risk-free investment. (Although U.S. Treasuries are called "risk-free" because they are backed by the government, their value is still at risk of being eaten away by inflation. And, it doesn't seem all that possible, but the government could default one day.)

So, if anyone ever offers you an investment opportunity that has "no risk," RUN AWAY because it is a scam.

That said, the amount of flucuation you can stomach is known as your risk tolerance. To help determine your level of tolerance, there are a ton of quizzes you can take. A couple of ones that I found legitimate were from Merrill Lynch and Rutgers University. The one from Merrill focuses solely on investment decisions, while the Rutgers one -- since it is actually a study on risk behavior -- is more broad and user-friendly, in my opinion.

Quizzes like these present you with questions that try to get at how much you are willing to lose for the chance of making gains. It may surprise you how much the magnitude of the potential gain matters versus the magnitude of potential loss. (I won't give it away; I'll let you take the quiz and find out for yourself!)

Some general rules/thoughts regarding risk are:

• If you're younger, you can take more risks. This is because of precious time your portfolio will have to recover from market losses. For example, if you'd invested $100 in the market on January 7, 2000, by December 27, 2002, you would have lost almost $41 dollars. Let's say you decided to hold on to those shares instead of selling them at a loss.* By December 28, 2007, you would have recovered your losses.* Holding for a brief period (that, in this example, was a terrible time for the market overall) would not have served you well, but over a longer period of time, you actually gain.
• Small-cap stocks tend to be riskier than medium- and large-cap stocks. This is because small-cap stocks are from smaller companies that are not as established, but have a lot of growth potential. Take Rocky Mountain Chocolate Factory, which operates in malls, primarily, in 40 states, Canada, Japan, and the UAE. This company is growing in different geographies, but since chocolate is not a commodity, its business can flucuate in hard economic times, so this investment would certainly be riskier than one in Hershey, for example, since the latter has been around for 100 years or so and has a strong global presence.
• Women tend to take fewer risks when investing. Common thought holds that women tend to be more risk averse when it comes to investing. Which could mean that a woman's retirement savings will likely be much lower than her male counterpart's. However, loss aversion can be useful. Women may be more inclined to make more thoughtful investment choices than men and stay out of overly risky investments. Some say that if more women were on the boards of banks, the financial crisis would never have happened.
• Stocks tend to outperform bonds. Historically, stocks have consistently outperformed bonds over time. From 1928 to 2012, the S&P 500 beat out ten-year Treasuries by more than 3 percentage points, which could be the difference between making $871 or $564 off of a $100 investment. It's good to have a diversified portfolio of stocks and bonds that complement each other, but stocks tend to have greater upside potential. Since bonds are debt, the bondholders, like a credit card company, are ultimately more concerned with getting their money back rather than what can be made on top of it. Equityholders, on the other hand, do not have to be paid back, so upside is all they can hope for; in exchange for taking on this risk, they get a higher reward. Get rewarded for holding stocks!

Don't be afraid to take risks, but if you don't have the funds to spare, do not risk them at all. It's much more important to pay down high-cost credit card debt than to start investing. But once you're free from that bondage, fly higher into stocks for [potentially] added financial security.

*Source: Google Finance S&P 500 chart.