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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