Do you know anything about investing? Do you know how stock and bonds are used for retirement planning? Do you know how to avoid excessive fees? Below I’ll outline some essential concepts to increase your investing knowledge.
 

Decide on an Asset Allocation 

Asset allocation is your personalized investment strategy. It is selected to balance risk and reward. In the most basic sense it is your ratio of stocks to bonds. More stocks equals more risk and more reward. More bonds equals less risk and less reward. 

Asset allocation can be more complex when considering international stocks, different types of bonds, real estate, precious metals, money market funds, I Bonds, etc. To learn more about what you can invest in and to help you decide on an allocation of funds see our post on the categories of assets in your asset allocation.

For people who save through their employer’s retirement plan there will be a menu of options to choose from. Each will include a description of what the fund invests in, how risky it is, past returns, etc. It would be good to speak to a financial advisor about these options if you have questions about how they work.
 

Monitor your Asset Allocation

It is a good idea to keep tabs on all your accounts and what they hold. You may be just starting out with a single retirement account right now, but as life takes its course you may end up with many accounts (employer 401k, spouse 401k, personal IRA, personal ROTH accounts, taxable brokerage accounts, etc). 

You could build your own spreadsheet to track everything. You could also check out our Net worth dashboard. If you don’t track your net worth across all accounts it is impossible to know what your actual asset allocation is.

Over time your asset allocation will drift away from where you want it. When it gets too far away from where you are comfortable (1-5%) it is time to rebalance back to where you are comfortable. 
 

Index Funds vs Actively Managed funds

There are two main types of funds to choose from - index funds and actively managed funds. There is a lot of debate as to which one is better.

Index funds are designed to follow the market. They may also follow a specific sector or region. The most common index funds are called “total market” which means they buy a small slice of everything out there. Your money is basically riding on the total economy with a total market fund. These funds are predictable in the way they follow the market, no surprises or hidden features that make your return different from what the total market got.

On the other hand there are actively managed funds. Managed funds have a boss (the manager) who decides what the fund owns day to day. The boss may favor certain stocks over others or try to time the market. Their choices are governed by the fund’s prospectus that outlines what kinds of assets the fund will hold and in what proportions. Many actively managed funds have vague language in the prospectus that allows the fund manager to use their judgment to try and maximize returns. Actively managed funds are more unpredictable than index funds because of the extra human element involved. Some fund managers do well and beat the market, others do poorly and earn less than the market. So with an active fund you could make more or make less. There has been a lot of criticism directed at managed funds for the way they can hide risk and “blow up” suddenly. There is also the sheer element of luck that guarantees some active funds will do better than others.
 

Read the Prospectus and Look for Warning Signs

When I was looking into REIT funds, I came across the following Fidelity Real Estate Index Fund FSRNX that had this language in the prospectus:

Normally investing at least 80% of assets in securities included in the MSCI US IMI Real Estate 25/25 Index. Lending securities to earn income for the fund.

Okay 80% or so in a real estate index, but what about the other 20%? Where is that being invested? They don’t say what is going on. You would have to dig into the fund’s published holdings to figure that out.

The last sentence “lending securities to earn income for the fund” also threw me for a loop. That sounds like shorting the market or selling options. Those can be pretty risky strategies and very different from a buy and hold mentality. 

This one didn’t mention using leverage but some prospectuses do mention that. Leverage means they are allowed to borrow to take on additional risk at times which magnify gains and losses. 

Active managers can use elaborate strategies to enhance returns. These strategies work most of the time but when they break down they fail big time. In these situations the manager is passing risk to the investors without them knowing it in order to make the numbers look good in the short term. However, when the fund has poor returns the manager moves on to the next job, but the investors are left holding the bag…

Full disclosure - I didn’t end up purchasing FSRNX. Do you own research and talk to a financial advisor before investing!
 

Check Expense Ratios

To make it easier for you to understand expense ratios, I will present you with a simple example of online shopping. 

If you live outside the US and want to buy something through Amazon know that the final price of that product will not be the same as shown on Amazon. On Amazon, you will pay the base price plus shipping for your country. When it comes to your country, customs duties are paid. That amount varies from country to country. Once you get the item the price turns out to be much more expensive than shown originally on Amazon.

So it is with the expense ratio, it is like a hidden fee that goes along with the investment. If you want to invest in a fund, know that you are paying the basic price, plus the hidden costs behind it. Thankfully expense ratios are required to be published up front and should be easy to find when comparing funds.

The lower the expense ratio is the better off you will be in the long run due to the power of compounding. If two total market funds are available and you like the prospectus from both, the one with the lower expense ratio is going to give you a better long term return.

If you have, for example, $100,000 in a fund and the expense 0.05%, you will pay $50 annually. If the expense ratio was 0.7%, you would pay $700. That is a big difference, but either way you won’t really notice it unless you keep a close eye on your statements.

The expense ratio fee goes towards the management of the fund, it breaks down into:

1. Management fees for a team of finance and investment experts who provide advisory services in the field of finance and investment, office space, salaries, trading fees, etc.
2. 
   Distribution fee (12b-1) means a set of costs that includes advertising, sales infrastructure, documentation sent to you by the fund to inform you about the news about the fund. Basically paying the fund to advertise it self.
    
3. Other costs are the most hidden costs that exist. These costs include several administrative costs such as costs of shareholder services, guardianship costs, legal and accounting costs, transfer agent costs. 

If you remember one thing from this post, remember to keep your expenses low.
 

Decide on Roth vs Regular IRA / 401(k) contributions

There are two main tax deferred investment choices in the US - pretax and post tax.

IRA / 401(k) / 457 / 403(b) funds are pre-tax. This means any contributions are tax deductible. If you earn $100,000 but defer $20,000 you are only taxed on $80,000. This can be a nice bonus, and the government is basically helping fund your retirement. There is a catch though, you must pay takes when you make withdrawals. There are also required minimum withdrawals that kick in later in life. If you think your tax rate will be lower in retirement pre-tax funds are a great way to go. Keep in mind there are some costly mistakes you can make with your 401k plan at work. Employees also need to know what happens to their 401(k) plan in the event of a job change.

On the other hand Roth / Roth 401(k) contributions are post tax. This means you pay taxes on your income, and then you contribute it. If you earn $100,000, you pay the full tax on that amount, and then you can contribute to your Roth account with that money. The good news is, Roth accounts are tax-exempt both when withdrawing money from the fund, including gains. So when it comes to Roth contributions taxes are totally out of the equation going forward. If you expect taxes to go up, or your tax rate to increase in retirement Roth is a great way to go. For more details about Roth IRAs, see our complete guide.

Doing a little of both to provide flexibility in retirement can also be a good option.

When you decide which retirement plan to use, it helps to automate it.
 

Conclusion: 

I hope this article has helped you learn more about investing and retirement planning. I hope it helped you learn something new and thus improve your investing IQ!