Three Investment Strategies
By: By Karen Hube Source: AARP The Magazine Date Posted:
Strategy No. 1: The No-Brainer
Invest in a lifestyle fund
Interested in keeping things as simple as possible? Lifestyle funds—which are funds of funds—may be your answer. These were created specifically for investors who want to invest in a single fund and be done with it.
"They're great if you don't want to oversee a lot of moving parts," says Christine Benz, associate director of fund analysis at Morningstar Inc., the Chicago-based mutual fund tracker. "And they handle an issue that tends to be very nettlesome—your asset allocation."
This is how they work. You choose a lifestyle fund based on your targeted retirement year. To make this easy, the funds are named by years. For example, if you're 56 years old and you're planning to retire at 65 (in the year 2015), you might select the Fidelity Freedom 2015 Fund or the T. Rowe Price Retirement 2015 Fund.
The fund divides your investments between stocks and fixed-income investments according to how many years you have until you plan to stop working. As you approach and move into retirement, the fund gradually adjusts the allocation to become more conservative. For example, the Fidelity Freedom 2015 Fund currently holds 58 percent in stocks and the rest in bonds and cash. By 2015 it will have less in stocks and more in bonds and cash.
If you like the idea of a lifestyle fund, your first task is to decide which fund company you want to work with. At least 15 fund families have lifestyle funds, and each of them offers about eight or nine funds geared to people with different retirement dates. T. Rowe Price, for instance, has the Retirement 2010 Fund, Retirement 2015 Fund, and more, in five-year increments, up to the Retirement 2045 Fund.
Each of their allocations differs—sometimes by a lot. Among T. Rowe Price, Vanguard, and Fidelity, the most aggressive funds are T. Rowe Price's, while Vanguard's are the most conservative and Fidelity's are moderate. For example, Vanguard's 2005 lifestyle fund has 31.4 percent in stocks, while T. Rowe Price's 2005 lifestyle fund carries 60.5 percent in stocks.
Also, as when picking individual mutual funds, keep an eye on expenses. The funds invest in a portfolio of underlying mutual funds, rather than individual securities. So you will pay the expenses charged by the underlying funds. Some lifestyle funds, however, charge you an extra expense on top of the underlying funds' expenses. (Look this up at www.morningstar.com.) Vanguard, T. Rowe Price, and Fidelity are among fund companies that do not charge these extra fees.
Strategy No. 2: El Cheapo
Stick with index funds
If you want a little more control over your portfolio than you get with a lifestyle fund but still want simplicity, consider investing in index funds.
These funds invest in a portfolio of securities that mirrors the indices they are trying to track. For instance, if you invest in a fund that tracks the S&P 500, an index of 500 large-company stocks, it will hold all the stocks in that index in similar proportion. For example, if General Electric makes up 3 percent of the S&P, the index fund will also hold 3 percent in that company. The performance of your fund will match the performance of the index it is modeled after.
These differ from the majority of funds, whose portfolios are actively managed by professional stock pickers. But here's the surprising thing about index funds: they beat actively managed funds about 80 percent of the time. True, when the S&P 500 takes a dive, so will your returns, but most actively managed funds are likely to have even bigger losses than your index fund.
What's more, average expenses on index funds tend to be much lower than those of actively managed funds. The Vanguard Total Stock Market Index Fund, which invests broadly across U.S. stocks, charges 0.19 percent, compared with the average 1.42 percent for U.S. stock funds. "These funds are a good way to get started," says Larry Carroll, a financial planner in Charlotte, North Carolina. "They're inexpensive, and you're not going to make any big mistakes if you invest in them."
That said, the returns of two index funds tracking the same index can vary, simply because one has higher expenses. For example, the three-year return through October 26 for the Vanguard 500 Index Fund was 11.72 percent, while the AIM S&P 500 Index returned 11.10 percent (both funds tracked the S&P 500, whose return was 11.86 percent).
All it takes to get started are two funds: one broad stock-market fund, such as Vanguard's, and a plain-vanilla government-bond fund, such as Vanguard Short Term Treasury Fund. Since the only difference between index funds is the cost, you might as well stick with Vanguard, which invented the index fund concept and whose expenses are rock-bottom.
Buy managed funds
One advantage of index funds is that they keep pace with the market. But the big disadvantage is that they can't beat the market. If you'd like to try, consider funds that are actively managed by pros. This
will take more effort on your part to select funds and keep tabs on whether your funds' managers are doing a good job.
Using the techniques discussed previously, divide your money between two well-diversified funds—one that invests in stocks and the other that invests in bonds. "If you get two good funds with good track records and good management, then two funds are all you really need," says Denise Leish, a partner at Money Plans, a financial-planning firm in Silver Spring, Maryland.
Over time you may want to add funds to boost exposure to other areas of the market. However adventuresome you become, though, don't exceed five funds, says Leish. If you add too many funds, you're bound to end up holding the same kinds of investments in more than one fund, which can throw off your asset allocation and won't give you any added benefit.
Also, when you select your funds, stick with mutual fund companies that have been in the business for at least five to ten years, such as Vanguard, T. Rowe Price, Fidelity, American, PIMCO, AIM, and Oakmark.
And, in the name of simplicity and keeping costs down, invest directly through the fund companies—rather than through a broker.
Regardless of which investment strategy you choose, be sure to check in once or twice a year to make sure your asset allocation is still on track. If you invest in index funds or actively managed funds and you started out with 70 percent in stocks and 30 percent in bonds, after a big surge in the stock market you may find your stock allocation has ballooned to 80 percent. Many funds, including lifestyle funds, include a provision for automatic rebalancing based on your investment goals, but others don't, so you'll want to check on them periodically and rebalance your portfolio accordingly.
Finally, aim to sock away 10 percent of your annual income, but don't get discouraged if you can't—every bit will count over time. Trying to find extra money? Write down all your monthly expenses and see where you can cut back, then have that money automatically withdrawn from your bank account each month. "Anytime you pass up a frivolous expense and save the money instead, pat yourself on the back,' says Lynn Ballou, a financial adviser in Lafayette, California. "That's what it's going to take to achieve financial freedom and security during your retirement."
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