How to choose your retirement investments in your portfolio

In this retirement series. last week we talked about where to set up our retirement accounts. Today, were going to talk about how to choose investments. Of course, I cant tell you which investments you should choose to help you meet your goal, but I hope this gets you started.

Note that were not researching individual stocks. Thats far too complicated, and for many its too risky. Instead, were interested in mutual funds (a collection of stocks and bonds from a variety of companies, selected by a fund manager) and index funds (the entire market, in its category).

Your 401(k) probably has a dozen investment choices. When I log on to my husbands 401(k) managed at Fidelity, I click on investment choices and research to see whats available to him: 3 large cap funds; 2  mid-cap; 1 small cap; 2 international; 11 target date funds; 2 bond investments; and 1 cash fund.

What in the world do any of those options mean?!

Large Cap(ital) Funds made with companies with a market value of roughly $10B+. Big, reasonably stable, established companies.

Mid Cap Funds made with companies with a market value of $2-10B.

Small Cap Companies with a market value of around $300M-2B. Smaller, possible up-and-coming companies. These are considered riskier than large cap, because theres more volatility with companies in this mix. These have potential for huge gains, or huge losses. Generally speaking, small cap funds are a great addition to your investment portfolio, but in small quantities. Well talk more about how much of each fund we should consider owning next week.

Bonds Investors are loaning money to the government or companies (depending on the type of bond). Considered a fairly stable investment, but with smaller gain potential than other options. (More: How to define a bond as a financial too l @Dummies)

Growth funds Funds with stocks expected to grow faster. Youll probably see large cap growth or small cap value or any combination of those options to further define the fund.

Value funds  Slower, steadier growing stocks (generally) and often pay dividends.

Blend A blend of growth and value

Why index funds are a great option

Index funds are a collection of many stocks all the stocks within its category. If youre looking at a large cap index fund, then its a fund containing all the large cap funds. If you buy an S&P 500 index fund, youd be buying a portion of all 500 stocks in that index, for example.

Did you catch that? 79%! Thats huge. Maybe youre among the lucky minority who beat the market, but its difficult for full-time professionals to do, and its certainly difficult to consistently beat the market. Hefty expense ratios for some of those mutual funds played a part. Index funds typically have really low expenses, because theres nothing really for a fund manager to manage. Heres more:

Its important critical to know a funds expense ratio, and if there are any additional fees associated with your investment account (such as front-end or back-end loads, which wont be included in the expense ratio). The expense ratio is just what it sounds like fees and expenses associated with that fund. A high expense ratio will eat into your profits. This is a BIG DEAL so dont overlook this step.

Use this calculator to see the impact of going with a fund with a low expense ratio (say, around .2%) vs. a high expense ratio (2%). To illustrate my point, lets say you have $100k in your retirement accounts right now. Assuming an 8% annual return, 3% inflation, and investing for 33 more years:

• Your account balance if you used a fund with a .2% expense ratio: $3,190,682
• Your account balance if you used a fund with a 2% expense ratio: $2,077,765
• The expensive fund would cost you $1.1M. Ridiculous and unnecessary!

Lets say youre comparing the impact of a fund with a .2% ratio with one with a 1% ratio: The same inputs as above would have you come out $562k ahead with the lower-fee fund!

At the start of retirement when you potentially have $1-2M+ in your portfolio, a high expense ratio can cost you more than a million dollars over your lifetime. Why pay a million dollars in unnecessary fees? Thats bananas!

Id say an expense ratio over .75 1% is starting to get up there. It could mean the difference between a comfortable retirement and having to work longer, or part-time.

Compare like funds with like funds. So, if youre seeking a good large cap value fund, compare that with other large cap value funds. Look at the expense ratios for both to see how they stack up.

Target Date Funds or Life Cycle Funds

If youd prefer to take a  hands-off approach to choosing your investments, consider a target date fund a.k.a life cycle fund. You choose a fund based on your projected retirement year. For example, my fund at Vanguard is called Vanguard Target Retirement Fund 2050 Fund  (symbol VFIFX).

Life cycle funds contain a blend of investments and its automatically diversified according to the year you want to retire. So, a life cycle fund for someone like me who has a long way until retirement will likely have a more aggressive blend of funds. Over time, the fund reallocates its funds, shifting to a more conservative portfolio.

You just keep putting money into this fund and you never have to rebalance it or diversify yourself its done for you.

Not all life cycle funds for the same years are the same. For example, Vanguards 2045 fund has a different set of holdings than Fidelitys, and so on. So, for your IRA its good to compare the specific asset allocation of each fund, and the expense ratio involved to see which offers the best investment for you. Some funds might be designed to be more conservative or more aggressive than another.

More  info:

• How to choose funds in your 401k @ Oblivious Investor
• How I choose between limited 401k options @ My Money Blog
• Best funds you can buy @ CNN Money. Shows a variety of funds in several categories (large cap, small cap, international, bonds, etc.) and types of funds (growth, value, blend, etc.). Shows year-to-date returns, and the 5-year return, and expense ratios. Helpful starting point for comparing similar types of investments to one another.
• The essentials of investing in stocks and bonds for dummies @Dummies

I just threw a lot of info at you (again). Look at the choices in your 401(k) to get an idea of whats available to you. Choosing funds for your IRA is potentially more overwhelming because youll have  more choices available. Overwhelmed with it all? Go with a target date fund and call it a day.

Next week, well talk about asset allocation how to determine the percentage of each type of investment within your portfolio.

If youve written about retirement recently, be sure to submit your post to the Carnival of Retirement. as Ill be hosting it here on Monday.