What is the most effective way of improving your retirement prospects?
When asked this question, many people would respond that the most effective way to improve retirement prospects is to pick companies that will outperform the market and invest in those companies, or hire money managers to pick outperforming companies.
If you could predict which companies would outperform the market and invest in them then your assets would grow more quickly. Yet 86% of active managers underperformed their benchmarks in 2014. In other words, if you chose to pick stocks or hire someone who did, you had an 86% chance of underperforming the market.
There is a better way. It begins with getting clear on what we can control and what we cannot control. We have no control over what the market does. Some asset classes will go up and some will go down. We do not try to predict which will go up and which will go down. We utilize asset allocation to invest in a diversified portfolio of stocks and bonds, so that no matter what happens in the market, we are confident that our portfolios will weather the storm.
Next, we look at what we can control. Two of those items are taxes and fees. We control taxes by using asset location. We put interest earning assets in tax-deferred and tax-free retirement accounts so that we reduce the taxes you are paying on your investment income. Those assets that produce little or no income but instead produce capital appreciation are held in taxable accounts.
And finally, we look to control fees. We do this by investing in low cost index funds and ETFs. By reining in investing expenses, we are diverting money that would have gone into an investment firm’s pockets back into your nest egg instead.
Unfortunately, many investments are saddled with high fees that can undermine your financial security. It is worth your while to identify the less expensive investment offerings in your 401(k) plan by checking out the investment performance and fee statement that your 401(k) plan must provide to you each year. To see how the fees in your 401(k) stack up against other plans, you can go to 401(k) Ratings directory at brightscope.com.
For money outside your 401(k) in traditional or Roth IRAs, or even taxable accounts, we recommend that you invest in ultra-low-cost investments such as exchange-traded funds. Or, better still, work with a fee-only advisor who invests in exchange traded funds who can help you to take advantage of asset allocation and asset location to achieve a financially secure retirement.