By Beau Kemp, CFP
Selecting investments in your retirement account offered by your employer can be confusing. Your investment choices are often limited, causing you to have to choose the best available fund from a list that may or may not be ideal. Understanding your own personal situation and which investments are available can make or break achieving your dream retirement one day.
A critical piece to investing is understanding your time horizon. As you accumulate money, you want to set a realistic expectation on when you will need to start withdrawing from your retirement account. The amount of time you have dictates the amount of volatility you can withstand and feel confident that you will be able to retire. Here are some general guidelines I like to follow:
If you have 15-20+ years until retirement: Time is your best friend. You can be invested in 100% equities and feel comfortable that you have plenty of time to wait until the market rebounds if there is a recession.
If you have 10-15 years until retirement: Depending on how you have handled volatility up to this point, you can either stay invested 100% in equities or start to introduce fixed income to your portfolio. Most likely, the maximum amount of fixed income you would want is 20-30%.
If you are within 10 years until retirement: Strategically constructing your portfolio to match your retirement needs is crucial to a smooth transition to retirement. The goal would be to have 10 years of retirement expenses covered by fixed income while still maintaining 60% or more exposure to equities.
Once you have figured out your time horizon, it is time to select which funds to invest in. Start by crossing out any active funds that are available. Active funds have a goal to beat their benchmark, often referred to as “the market.” Since they are actively trading, they will charge you more to manage the fund. No one has been able to consistently beat the market over a long-time horizon, so it is foolish to pay more every year and not achieve a greater long-term return.
Usually, this will leave you with a few passive index funds to choose from. From a region exposure standpoint, a good start would be to mimic a total world index fund. These funds usually have about 60% invested in U.S. equities and 40% in international. A total world index fund will have a large exposure to large-cap equities. From there, we like to deviate from the traditional allocation of large-cap equities and expose our portfolios to more small-cap value and emerging market funds. The reason for this is because historically they have had greater returns over a long-time horizon. Greater returns come with greater volatility, so you must be willing to accept years of underperformance.
Investing for retirement is like a roller coaster ride. If you can handle steep peaks and valleys throughout your ride, you should feel confident in investing in passive index funds with a large tilt towards small-cap value and emerging markets. If you feel like you won’t be able to handle a steeper ride than “the market” then you should invest in a more traditional way (total world index) with more exposure to large-cap funds. A lot of investors feel most comfortable having a mix of large- and small-cap funds. The most critical decision of all is to find the ride you can stay on throughout your entire time horizon!
About the author: Beau Kemp, CFP
Beau Kemp, CFP®, is a financial planner at Sensible Money. He started as an intern while finishing his final semester at Northern Arizona University and has enjoyed seeing the impact a financial plan has on a person’s life ever since!