How to Build a Retirement Portfolio in a 401k or IRA for Ages 18-40
Building a retirement portfolio can be very confusing, especially when you are handed a list of potential mutual fund investments available in your 401k and you have no knowledge of how they are supposed to go together to form an investment portfolio. It can be even more daunting to invest an IRA you just began funding as the investment options often appear limitless. Target date funds can offer an easy way around picking multiple mutual funds or ETFs to include in your portfolio, but unfortunately not all target date funds are created equal and picking the wrong one could end up costing you a large sum of money. Before making any fund mutual fund or ETF selections in your retirement portfolio, you will first want to understand generally what a retirement portfolio should look like at ages 18-40 when properly allocated among investment types, keeping in mind that investors in this age bracket can afford to take more risk than those who are approaching retirement and consequently their portfolios should be more heavily weighted to common stock (equity) than to bonds.
401k: How do I Choose Which Funds to Invest In?
In a 401k your options will likely be limited and in that case you will want to either select the appropriate target date retirement fund (make sure you look into these funds before investing in them; I will discuss later) or build a basic portfolio using your options that is similar to one of the below charts, depending on what is available:
Next check that the target date fund you would invest in is at least similar to one of the above asset allocations. There may be additional asset classes in the fund but it should be roughly the same. In my case the target date fund I would have to invest in is the 2050 Fidelity Adviser Fund (to the right). This is an example of an overly complicated non-transparent fund that I would stay away from. First of all, the fees are 1.29% which is high.
Secondly, there appear to be actively managed funds in the portfolio that have unclear investment strategies (actively managed means that investment managers are choosing which stocks/bonds to invest in and when to buy and sell them). I prefer to see index funds in a target date portfolio as there is conflict of interest when a fund company picks the funds that will be in their target date fund (they may be more expensive funds or funds with unproven portfolio managers. Target date
fund managers may do this to increase assets in underlying funds that would otherwise remain small and dissolve). You can tell a fund is an index fund because they typically have the name of the index they replicate in their name (S&P 500 is large cap, Russell 3000 is all-cap, etc.). Thirdly, the Fidelity fund i am looking at has a 12% cash position, which is quite high especially at my current age; I would like to see cash no greater than 1-2%. It may be that they are counting the commodity strategies’ cash and adding up the cash of all of the funds in the portfolio; either way this amount of cash is a red flag without additional explanation. I was not pleased with the complexity and opaque nature of the Fidelity target fund available and therefore I chose to put together my own allocation based on my above basic recommendations for 401ks.
Roth IRAs and Traditional IRAs: How do I Pick Investments When There Are So Many Options?
While you could spend days poring over your investment options, I personally I prefer Vanguard ETFs and mutual funds as they tend to be one of the least expensive managers of index funds around (at least as far as management fees are concerned). In my case I have to pay commissions on Vanguard funds and therefore I have had to find alternatives (I plan to build my IRA portfolio with the iShares ETF products that I can trade for free on Fidelity in conjunction with a few mutual funds to get exposure to asset classes not offered in my free-to-trade ETF options). When selecting index ETFs the number one thing to concern yourself with is cost; the lower the better.
If you prefer to let someone else invest your portfolio, the Vanguard target date funds offer well priced indexing target date options (under 0.20% management fees) that will be very similar to creating your own indexed allocation such as those I outlined in the above basic target allocations for a 401k. For me personally I like to be in more control of the weights of the assets in my portfolio; however, a target date fund is a great place to start if you don’t have the assets to put together a more complex allocation such as the example below.
When it comes to obscure asset classes such as emerging market bonds or high risk bank debt (if you want an even more diverse portfolio), I would advise doing some serious research on funds before you invest. As long as you stay with indexing you can cut your research time significantly and take comfort in the fact that you will not greatly under-perform or outperform the asset class of that particular index. Remember that no matter how complex or simple you make your portfolio, if you fall in the 18-40 age bracket you should end up with the same rough portfolio allocation of about 50% domestic equity, 30% international equity, and 20% bonds.