A Proposal - Step 3

Ok...so here's the deal. We started our career and recognize that we are responsible for our own retirement. But we've had no training or education on how to achieve that retirement. So, we start by saving at least 10% of our gross income and doing that by putting it into our company 401(k).The specific investment we select is the retirement date Fund corresponding to when we are in our mid 60s.

And then we go to work, live our life and get promoted and maybe get bonuses. Some people of course will find it difficult to save at least 10%. It is very easy to have your lifestyle adjust to whatever income you have. Interestingly there are professional athletes raking in millions who for the life of them cannot apparently save a cent.

I have found that if you fortunately are in a position to get raises and promotions as time goes by and don't automatically increase your lifestyle each time then you should be able easily to meet the 10% and higher saving goal.

Anyways...get it done. Sit down and have a face-to-face with your 65 year old self and let him or her know that you are doing it for them. While you're at it motivate yourself by recognizing you are doing it for the kids. The last thing they want is a broke mom and pop when they are trying to get their family going.

So, we're saving, time goes by, as it always has, and we reach a point where the 401(k) is starting to reach a decent size. For the sake of argument we can take this to be $80,000 or so. The next phase comes into play. At this point you may want to consider investing in individual Funds within your 401(k). This should save you .50% or so annually. This may not seem like a lot but when you consider the savings over 25 to 30 years it becomes meaningful. And the beauty of it is that it isn't difficult.

As an aside you don't have to do it. If you deem your efforts better used in other areas then stick with the target date Fund approach.

So, how do you use individual Funds? Take a look at your 401(k) Fund offerings. They hopefully include low cost index Funds. For the sake of argument assume that Fidelity is your 401(k) Fund advisor. Assume as well you have been investing in the Fidelity Freedom 2050 Fund, ticker symbol FFFHX. If you go to www.morningstar.com and put the ticker symbol in the quote box you find that FFFHX has an annual expense of .77%.

The new approach of using individual Funds would include FUSEX, an S&P 500 Fund (.09%), FSGUX, a global ex U.S. Fund  (.18%), FBIDX an Index bond Fund (.15%), and FSSPX, a small cap index Fund (.19%). The respective annual fees for the Funds are shown in parentheses.

You can use these 4 Funds to set up your asset allocation. For example, if you are 40 years old you may decide to allocate 70% to stocks and 30% to bonds if you are fairly comfortable with some portfolio volatility. If not, reduce the stock allocation to 60%.

For your stock position you may want to have 15% in the global Fund, FSGUX, and 5% in the small cap Fund, FSSPX. The global Fund gives diversification and exposure at the present time in a part of the market that hasn't done well. The small cap Fund increases volatility a bit in a sector that has provided higher returns.

You'll undoubtedly notice that this simplifies your investment setup. The 2050 Fund is comprised of many more Funds. Which is better? Wouldn't the greater complexity and more Funds in the 2050 Fund mean better performance? Actually, we don't know unless we have the proverbial "crystal ball".
The simpler structure does however mean that it is easier to understand and analyze and the fact that it saves approximately .5%/year means that over the long term it has the odds highly in its favor to meaningfully outperform.

To recap: on day 1 of starting your career you elect to have at least 10% of each paycheck go into the target date Fund offered by your 401(k).  After a few years go by and it has reached a sizable amount consider investing in individual Funds in order to reduce the annual expenses. This will take you to your mid 60s at which point your goal shifts meaningfully from getting growth of your portfolio to generating an income from your portfolio. That will be the subject of the next post.

Let me reemphasize that you don't obviously have to follow this approach. You may feel you are a great stock picker. You may believe you can time the market. If so, go for it with my blessing. Just understand that the odds are extremely high that you are wrong and that it could be very costly learning that fact.