Skip to main content
PDF Download Download the 6 Rules PDF

Saving Smart for Retirement

Making smart investment choices

Most investors, both institutional and individual, will find that the best way to own common stock is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment choices.1

— Warren E. Buffet, 1996 Annual report of Berkshire Hathaway Corporation

I'm ready to save. Now what do I do?

Anyone who has ever set up a 401(k) account has asked these important and challenging questions...

  • Should I buy funds made up of stocks, bonds, or a money-market – or all three?
  • What's the right choice for me?
  • How many funds do I really need?

And that's just for starters!

Yes, investing can seem intimidating. But we're convinced that if you make diversified and cost-efficient choices, you can find it easy, and even fun, to save for tomorrow.

If you haven't done so already, may we suggest that you read the companion guide titled Five Rules for Creating a Sound Investment Strategy. It contains useful information on how to allocate your savings among the various asset classes.

The guide you're reading now will provide you with some important background information and explain how to choose the right types of investments and create a portfolio mix designed to help you meet your savings goals.

An important word about risk: It's important to remember that investing in stocks involves risk. Markets may or may not act in the future the way they have in the past. However, we believe that by following sound principles and applying them consistently over time, you can get on track to meet your goals and achieve financial peace of mind.

6 rules for making smart investment choices

Rule 1 — select index-based funds for maximum diversification

ShareBuilder 401k advocates using index-based investments for your long-term savings plans. Why? Because index-based funds tend to be well-diversified and have low expense ratios, so your money can work harder over time. We believe this so strongly that our entire ShareBuilder 401k offering is comprised of a particular kind of index-based funds called Exchange Traded Funds (ETFs).

Index-based funds hold a portfolio of securities or bonds that work to mirror those comprising a market index (like the Dow Jones Industrial Average or the S&P 500). The goal of these funds is to match the performance of the index it tracks, less the costs needed to run the fund (the expense ratio).

Investments that track the major indexes are by their nature diversified, which means you're not putting all your eggs in one basket.

Rule 2 — costs really do matter

Index-based funds also offer the great advantage of cost efficiency. The following example illustrates why costs matter so much and why knowing the expense ratios of your investment selections is so critical.

Consider these results: From 1980-2005, the S&P index-based mutual funds averaged 12.3% net return (12.5% gross return less 0.2% expense ratio). The average mutual fund provided a net return of 10.0% during the same period. In other words, investors gained a 2.3% advantage by owning the index-based funds.

Compare how this adds up over time for a single $1,000 investment made in 1980:

Net return of $1,000 (1980-2005)2
S&P $17,080
Average Mutual Fund $9,820
Advantage: $7,260

 

IMPORTANT: Costs can be a real drag on your fund's ability to produce outstanding results for you. The reason index-based funds are cost-efficient is that you're not paying for an expensive active fund manager or the extra costs associated with higher portfolio turnover that are more typical in actively-managed funds.

Because actively-managed funds often charge expenses that are 1-2% above those of their index-based fund peers, index-based funds can be tough to beat over the long run.

Rule 3 — keep it simple with a few well-diversified funds

Don't worry – if you're confused about which investments to make, you're not alone. It should come as no surprise that many people find it hard to make investment decisions.

Some providers offer over 100 options in their 401(k)s alone. Invest at any retail brokerage and you can face over 10,000 investment products! The simple fact is, you can have a prudent, well-diversified savings plan with just one investment, often referred to as a model portfolio.

A closer look at model portfolios. Model portfolios consist of a specially selected basket of funds, allocated across stocks, bond, and cash instruments in different ways. Model portfolios are developed and balanced to meet the needs of specific investor profiles that take into account your risk tolerance and time horizon until retirement. (See the Three Sample Portfolios to Consider on a later section of this guide for more information.)

You may have heard of target or life-cycle funds. These are a form of model portfolios that adjust asset allocations as you get closer to actually using your funds in retirement.

For those that prefer to choose their own investments, a well-diversified selection strategy might be to choose one broad stock market index-based fund and one bond market index-based fund.

Rule 4 — choose the right mix of stocks and bonds

Asset allocation simply refers to the process of deciding how much of your money goes into which kind of investments – stocks, bonds, or cash. Experts and respected studies indicate that your asset allocation is the most important decision you'll have to make. It's even more important than choosing specific funds.

Some important performance facts. Since 1926, U.S. stocks have delivered 10.4% returns, bonds 5.4%, and cash 2%.3 And since 1960, inflation has averaged 4% a year. It stands to reason that a sizeable amount of your investment should be in stocks.

Watch out for volatility. Given the fact that stocks have historically provided better returns than bonds and cash, why wouldn't you put all your savings into stocks?

There are two answers to this question.

First, there's no guarantee of future returns. Past results are not a guarantee of future results.

Second, stocks have had years when returns were over 20%, and periods where they have declined 20% or more. Remember the Internet bubble that burst in 2000?

Because the stock market is volatile and bonds are often worth more in periods when stocks are going down (and vice versa), investing a percentage of your savings away from stocks is a good idea. You'd hate to reach retirement age at a time when stocks are down significantly and you have no other investments!

Put time on your side. It's a simple fact: the more time you have until retirement, the more time you have to travel safely through market ups and downs. A person in her mid-twenties might consider investing more in stocks – upwards of 90% – and just 10% in bonds. A person who is 62 and will be retiring in three years may be better served with an allocation of 60% in stocks and 40% in bonds. Remember, even at 65, you won't be accessing all of your stock funds for 10 or 20 years or more. This gives you some time to ride out the inevitable storms ahead.

What's your tolerance for risk? When it comes to investing, it's extremely important to know yourself. If you're uncomfortable seeing your savings swing with the markets, or lose value for a period of a year or more, you should build a more conservative portfolio comprised of perhaps 60% in bonds and 40% in stocks. If you take a conservative approach, you may not reach you goals quite as fast, but you'll likely sleep a whole lot better at night.

Three sample portfolios to consider. It's impossible to suggest a specific portfolio in this guide, because everyone's needs are different. Your specific time horizon, current financial situation, goals, and risk tolerance all have to be taken into account. Given this fact, we present below three sample portfolios for you to review. They are appropriate for people in different life stages. They demonstrate how ShareBuilder 401k funds can be used to align with a designated asset allocation goal to provide a custom financial solution for you.

Young Investor
Asset Allocation Percent Potential ShareBuilder 401k Funds Fund Goal Ticker
Domestic large-cap stocks 55% Vanguard S&P 500 ETF Seeks to track the S&P 500 Index VOO
Domestic mid-cap stocks 15% Vanguard Mid-Cap ETF Seeks to track the CRSP US Mid-Cap Index VO
Domestic small-cap stocks 10% iShares Core S&P Small-Cap ETF Seeks mirror the performance of the S&P 600 Small-Cap Index IJR
Intermediate-term bonds 20% Vanguard Total Bond Market ETF Seeks to track the performance the broad, U.S. investment-grade bonds market as compared to the Barclays U.S. Aggregate Index BND

 

Middle-Aged Investor
Asset Allocation Percent Potential ShareBuilder 401k Funds Fund Goal Ticker
Domestic large-cap stocks 50% Vanguard S&P 500 ETF Seeks to track the S&P 500 Index VOO
Domestic mid-cap stocks 10% Vanguard Mid-Cap ETF Seeks to track the CRSP US Mid-Cap Index VO
Domestic small-cap stocks 5% iShares Core S&P Small-Cap ETF Seeks mirror the performance of the S&P 600 Small-Cap Index IJR
REITs (Real Estate Investment Trusts) 5% Vanguard REIT ETF Seeks to track the return of the MSCI® US REIT Index, a gauge of real estate stocks VNQ
Intermediate-term bonds 30% Vanguard Total Bond Market ETF Seeks to track the performance the broad, U.S. investment-grade bonds market as compared to the Barclays U.S. Aggregate Index BND

 

Retirement-Preparation Investor
Asset Allocation Percent Potential ShareBuilder 401k Funds Fund Goal Ticker
Domestic large-cap stocks 40% Vanguard S&P 500 ETF Seeks to track the S&P 500 Index VOO
Domestic mid-cap stocks 10% Vanguard Mid-Cap ETF Seeks to track the CRSP US Mid-Cap Index VO
Domestic small-cap stocks 5% iShares Core S&P Small-Cap ETF Seeks mirror the performance of the S&P 600 Small-Cap Index IJR
REITs (Real Estate Investment Trusts) 5% Vanguard REIT ETF Seeks to track the return of the MSCI® US REIT Index, a gauge of real estate stocks VNQ
Intermediate-term bonds 20% Vanguard Total Bond Market ETF Seeks to track the performance the broad, U.S. investment-grade bonds market as compared to the Barclays U.S. Aggregate Index BND
Inflation-protected funds 20% iShares Barclays TIPS Bond Seeks to mirror the Barclays U.S. Treasury Inflation Notes Index TIP

 

Rule 5 — tax-advantaged accounts can save you money

For those who invest in non-tax-deferred accounts – i.e. outside of an IRA or 401(k) – taxes can really take a big bite. Between dividends and short-term and long-term capital gains, taxes can eat up an investor's return. The amount of turnover in a fund, and other factors outside of your control, contribute to the tax problem. A Charles Schwab study showed that high-tax-bracket investors can lose more than half of their returns to taxes in a non-tax-deferred account versus holding the same investments in a tax-deferred account like an IRA or 401(k).4

This is a major reason why most financial experts recommend 401(k)s and IRAs as the number one place to save for a secure retirement.

Tax advantages help you save more. With the government's blessing, 401(k)s and IRAs come with built-in tax advantages designed to make saving more attractive. Traditional 401(k)s are designed with three features that encourage participation and saving:

  • Your pre-tax contributions get a tax break today. This means that the amount you contribute from your paycheck is not taxed. But once you withdraw that money in retirement, the government taxes it as income – growth and all.
  • Loans and hardship withdrawals are available. The interest, though, must be paid back to your account. However, if you do not repay your loan to your 401(k), those funds withdrawn before the age of 59½ are subject to taxes plus an additional 10% penalty. NOTE: We do not recommend taking loans from your 401(k) unless absolutely necessary as these loans will negatively affect retirement savings growth.
  • You can take your money with you. If you leave (or are an owner who sells your company), you can move your funds to the 401(k) plan of your new company or move it to an IRA without any tax penalty. In other words, you can continue to save for retirement without incurring tax liabilities due to changing jobs.

How to enjoy a tax-free retirement. Thanks to the latest round of legislation, the Roth 401(k) is available as a permanent option for participants. A Roth 401(k) offers you and your employees the option to invest some or all of your paycheck contributions after taxes. You benefit because your Roth 401(k) contributions and earnings cannot be taxed again upon reaching retirement age. Any and all profits that were generated by these investments will grow tax-free. And unlike its IRA Counterpart, there's no qualifying income limit.

So what's the catch? There is no catch, but your paycheck will take a bigger tax hit today. If you can afford to take the hit, you stand to benefit greatly come retirement when that money could really come in handy.

Does a Roth make sense for you? It all depends on whether you think you'll be in a higher tax bracket in retirement, and whether or not you can afford taking home less pay today. There are significant advantages to putting some or all of your contributions in a Roth 401(k). The younger you are, the better off you'll probably be, since workers in their twenties and thirties are more likely to move up the ladder over time into higher-paying jobs. This means they're in the best position to benefit from compounded growth over time.

To see just how much more money you could make, let's take a look at two investors in a hypothetical example. Both are 45 years old, making $75,000 annually, and both will retire at age 65 with a retirement span of 20 years. One chooses to put 8% of his income into a Roth 401(k); the other opts to contribute 8% to a traditional 401(k):5

More Income in Retirement: Traditional Pre-Tax 401(k) or Roth 401(k)?
Age 45 earning $75K per year Pre-tax 401(k) Roth 401(k) A look at the numbers
Take-home pay pre-retirement $1,035,120 $1,005,120 Pre-tax 401(k) saves you $30K, a monthly take home pay advantage of $369
Nest egg at age 65 $294,510 $294,510 Savings are the same, given the same contribution percentage and rate of return
Post-tax retirement income $502,560 $591,120 Roth 401(k) will provide you with $88,560 more in retirement
Advantage: Roth 401(k)   $58,560 Roth wins this scenario with $58,560 more for you to live on

 

In this simple example, the Roth investor comes out ahead by $58,560. We strongly recommend you run some numbers of your own to see what makes the most sense for you. You may even wish to hedge and contribute to both types of account, so that you stand to benefit no matter where you end up.

Rule 6 — put your savings plan on "autopilot"

Financial experts agree that the best way to make a savings plan work is to make the process automatic. Most people these days live hectic lives, which makes it hard to stay on top of your investments. That's a great advantage of a 401(k); it can put your savings plan on autopilot. This means that each pay period you'll automatically contribute the amount you elect to your individual 401(k) account and into the specific investments you select. It couldn't be easier!

Some providers even offer auto-rebalancing as a feature, so your asset allocation (how much you have in each investment) is reset to your desired mix or percentage. That's another useful tool that can help you meet your goals.

Summary

Keys to making smart investment choices

  • Select index-based funds for maximum diversification
  • Costs really matter – select low expense-ratio funds (like ETFs)
  • Keep it simple – you only need a few well-diversified funds
  • Choose the right mix of stocks and bonds for you
  • Take advantage of 401(k) tax benefits
  • Put your saving plan on "autopilot"

We hope these tips have helped you get ready to invest and save with confidence. The process really isn't as hard or intimidating as "Wall Street" makes it seem. Just get started and discover for yourself how easy it is to start saving for a secure retirement.

Read more

Start with our companion guide, Five Rules For Creating a Sound Investment Strategy. It's loaded with practical, valuable information to help you put together your saving and investment plans.

Other online resources:

Want to learn even more? Then let us suggest these books to help you invest with confidence:

  • Bill Shultheis, The Coffeehouse Investor — a little book with a great message on how to invest and keep it simple
  • Frank Armstrong III, The Informed Investor — a straightforward overview of how the market works
  • Benjamin Graham, The Intelligent Investor — the renowned and thorough book for investors
  • David Bach, The Automatic Millionaire — an easy, one-step guide to help make saving automatic

Next Steps

Watch a Demo »

Receive a Quote »

Get a 401(k) Overview »

Call Us

401(k) Consultants are available
Monday - Friday, 9am - 8pm EST
800-943-6108 x1