Use a Simple Method to Choose Investment Options (58/365)

When people sit down with their retirement advisor to sign up for their 401(k) or other retirement plan, they often think it’s just a matter of signing a few documents and deciding how much to have held out of their check each pay period.

Then, when the advisor shows them a plethora of investment options, they lock down. They’re unsure which one is the right one and, often, they have a sense that if they choose the wrong one, they’re either going to get ripped off or that they’re going to have really poor investment returns.

Often, they go into lockdown. They put the papers aside for “later,” then never return to it.

I’ve known several people who have followed this exact path (one of them is pictured below), and had hundreds of readers email me with a similar story. It’s a financial mistake to not start saving for retirement immediately, but in this situation, it’s a bit understandable.

Use a Simple Method to Choose Investment Options (58/365)

Fortunately, there’s a simple recipe you can follow that will help you pick at least a very good retirement option among the ones offered, if not the best one.

The first thing I’d do is look for a “target retirement” fund. These are special investments that are specifically designed for people who are aiming to retire in a specific year. For example, you might see a “Target Retirement 2040″ fund, designed for people who are aiming to retire in or near 2040.

The way these funds work is that when the “target” year is far away, the funds are mostly invested in stocks. Stocks earn a very nice return over a long period of time, but can be very volatile, meaning you don’t want to hold many of them if you’re going to need the money soon because the price might rapidly drop in the short term.

As that target date edges closer, the people who run the fund slowly move investments out of stocks and into more stable things like bonds and cash. Your money won’t earn as big of a long-term return, but it won’t lose much value, either.

These plans work really well for retirement savings and, as a general rule, I recommend them to everyone as their default choice for retirement savings. If your retirement plan has one, choose this.

What do you do if they don’t have target retirement funds? Much like with the target retirement funds, you don’t want to have everything in stocks and, as you move towards retirement, you want things to gradually be safer. Here’s how I handle my own retirement savings in my account that doesn’t have “target” funds.

First, I looked at the investment options and identified the investment in stocks and the investment in bonds with the most diversity. What you’re trying to do here is find investments that have fingers in lots of different industries but aren’t overloaded in any one particular industry. Usually, these are called something like a “total stock market” fund or a “total bond market” fund.

Next, I figured out my retirement age and the number of years until retirement. I was 25 at the time and I wanted to retire at 65. Thus, I had 40 years until retirement.

After that, I doubled the number of years until retirement. Since I had 40 years to go, the number I wanted was 80.

That number is the percentage of my savings I put into the stock fund. I put 80% of my savings when I signed up directly into the stock fund. The rest I put into the bond fund.

Every five years after that, I rebalanced things. I re-did the calculation (at age 30, that meant I had 35 years until retirement, which meant that I wanted 70% in stocks and 30% in bonds), and then I moved my retirement savings and contributions around until it matched the percentages I wanted.

Here’s an example. Let’s say at age 25, I started putting $80 a week into a stock fund and $20 a week into a bond fund. At age 30, the stock fund had $27,456 in it, while the bond fund had $6,344 in it. This was due to the gains earned during the five years of investing.

The total amount I had saved for retirement, then, was $33,800. I wanted 70% of that in stocks – $23,660 – and 30% in bonds – $10,140. The reason is that I was slowly making my retirement savings more conservative and less prone to stock market risk.

So, to make this change, I simply requested that I move $3,796 (the $27,456 I had minus the $23,660 I wanted) from the stock fund to the bond fund and changed my contribution to be 70% in stocks and 30% in bonds.

At age 35, I’ll do it again.

The key thing is to not be afraid to invest. Don’t put off investing because you’re not sure what to invest in. Instead, make a sensible choice (using the guidelines I mention here) and start saving now. If you don’t like the choice, you can always change it later, but you can’t get back the months and years of not saving.

This post is part of a yearlong series called “365 Ways to Live Cheap (Revisited),” in which I’m revisiting the entries from my book “365 Ways to Live Cheap,” which is available at Amazon and at bookstores everywhere. Images courtesy of Brittany Lynne Photography, the proprietor of which is my “photography intern” for this project.

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25 thoughts on “Use a Simple Method to Choose Investment Options (58/365)

  1. kc says:

    …it all started with that damned yellow Neon. Now look at me! I’m driniking Busch beer and I’m somebody’s idea of “simple.”. Sigh. Where did I go wrong?

  2. Tracy says:

    kc, that made my day :)

  3. Johanna says:

    @kc: Watching TV and using the slow cooker in the garage might have something to do with it.

  4. Mister E says:

    What a happy looking family Brittany Lynne has.

    I’m glad that this photo is in profile, just to remove any doubt that it is in fact as awkward as it could possibly be.

  5. Availle says:

    I like the picture.

    And it’s neither necessary nor possible to be “happyhappy joyjoy” 24/7. Are you, Mister E?

  6. Mister E says:

    Of course not.

    But if I was posing for a picture that was to be published on a website for thousands to look at, I could probably manage a smile. Or even if I was posing for a picture to be viewed only by close friends and family for that matter.

    I would also probably request that I be shot from a more natural angle, but maybe this guy just really likes his right ear and wanted to make sure that it got the spotlight that it deserved.

    It is a pretty great ear.

  7. jim says:

    “sit down with their retirement advisor”

    OR in my experience :

    “handed a pile of papers and forms to fill out by the HR person performing the new employee orientation”

  8. Kai says:

    Have you seen the rest of the series? The amusement isn’t that this guy doesn’t look super excited, but that every single photo has had the people looking close to miserable.

  9. kevin says:

    Ok – how does this pic relate to the post? Trent must be “mentoring” Brittany on the fine are of phoning it in.

  10. valleycat1 says:

    #9 kevin – Trent says this is one person he knows who was overwhelmed by the options & did nothing.

  11. Vanessa says:

    Then, when the advisor shows them a plethora of investment options, they lock down.

    Lock down? I guess that’s a combination of lock up and shut down?

    If the man in the photo has regrets about investing, I would’ve liked to hear them from the man himself. Too much financial advice (especially about retirement) comes from people too young to know if their tips really do work in the long run. Hearing this gentleman’s perspective would’ve been a nice change of pace.

  12. Johanna says:

    Maybe Brittany could give us a whole year’s worth of pictures of random people, then Trent could introduce them as “Here’s a person I know who makes powdered laundry detergent,” “Here’s a person I know who rides a bicycle,” “Here’s I person I know who opted out of courtesy overdraft protection.”

  13. krantcents says:

    What works for me is small changes! I may change just one investment choice in a year or two. Keeping to just one change every year or two is easier to deal with.

  14. Alice says:

    I think this guy is a bit older than yellow neon guy; it would be interesting to have background information about these people and why they agreed to participate in this (I’m wondering what sort of input they have into the post they will illustrate).

    Even though this person apparently delayed saving for retirement so he’s arguably relevant to the post, it seems classist to use a photo of a casually dressed person in a modest environment to illustrate the concept of a “simple” method to choose an investment plan. I’m not sure if the meaning is supposed to be that delaying saving for retirement could mean golden years spent drinking Busch beer in the garage, or if this guy ended up in the garage because there wasn’t a “simple” enough investment plan around to address the needs of folks who drink beer in the garage. In conjunction with the post, the photo (which may just be a guy relaxing the way he wants to) perpetuates the stereotypes discussed in the morning post.

  15. Julia says:

    I think this is why my company picked a default plan. I’ve been in my company’s 401K plan for a few years now. I still lock up when I look at the investment options. But my plan is still growing. I might be able to do better if I paid more attention to the options, but it’s doing ok right now. Much better than it would if I had to pick options before I started saving.

  16. Bookaunt says:

    So by this formula, you would be 100% in bonds by the time you retire? That seems a little too conservative. I think I prefer the formula where you subtract your age from 100 to get the percentage of stock holdings (75% at your age 25 example, but 35% at age 65). Since I anticipate living a long time in retirement, I am going to continue to want to keep some money in equities.

  17. Mark Gavagan says:

    Trent,

    As #16 points out, with your system, it seems you’d be 100% in bonds at retirement (possibly with decades of life ahead of you from that point forward).

    There’s nothing here about why your approach would be more effective than others, or any data about how well or poorly it’s worked compared to other approaches.

    You also don’t mention risk tolerance or fees from one fund option to the next.

    You are very capable of writing about many topics, but so far, investing does not appear to be among them.

  18. Kevin says:

    Thanks Valleycat – I usually skim the post and go straight to the comments.

  19. Tom says:

    Whatever to the picture and the content, I’d like to point out how unprofessional I think the Adsense in the middle of the article looks.

    Anyone else feel like this blog is accelerating over the proverbial shark tank as we speak?

  20. Gretchen says:

    Tom, (and I guess Trent), I’m having a lot of trouble loading the site lately. Perhaps it’s just my computer.

  21. AnnJo says:

    So-called “target” plans have only been around for a few years, so there is absolutely no track record on how well they will do in the long run. And the idea of aiming to be 100% in bonds and cash by the time you retire is simply absurd.

    Most people are willing to accept that they might have to spend a year or two, if not conisderably more, in full-time study to prepare for a career of 20-30 years or so (and more years after that education paying off their student loans).

    Why the unwillingness to accept that it might take a few years of part-time study to learn enough to manage your investments in preparation for 15-35 years of retirement? If your eyes glaze over looking at investment options, start studying!

    A basic macroeconomics class, a couple of accounting and finance classes, and some careful reading of a few good economics, finance and history books will put the average person with a decent high school education far ahead of the average retirement planner in understanding the forces that shape investing over the long run as well as the ability to read the financial statements that are available for most investments.

  22. Evita says:

    Those photos of grim-looking people always make me ill at ease. They add nothing to the post and generate loads of unflattering comments. Why continue doing this ?

  23. BirdDog says:

    I have a gut feeling that the gentleman in the photo is Trent’s father. I could be mistaken, of course, but something makes me think that.

  24. David says:

    I would strongly recommend to every reader of this blog, and to its author, a book called Thinking, fast and slow by the psychologist and Nobel laureate (for economics) Daniel Kahneman.

    Since its central thesis is that whether you end up ahead of the market or behind the eight ball is almost entirely a matter of luck, you will not find this book highly commended by anyone who thinks that he or she knows anything at all about finance.

    Not that this worries Kahneman particularly, because he believes – and he has a vast body of evidence in support of his belief – that nobody knows anything at all about finance anyway. If you want to pick a stock, or a bank, or a retirement plan, you should hire a chimpanzee and a dart board. They will, in the vast majority of cases, comfortably outperform anyone who might be considered a dispenser of “good” economic or financial advice.

    As to history, it is written by the survivors. But these are not ipso facto better qualified to predict posterity; it’s just that the dead can’t.

  25. jim says:

    To David’s point, A while back I compared a chimp’s stock picks to Jim Cramer and the chimp was winning more than not.

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