Note: This post is not intended as personal or personalized advice. It is provided for informational reference only and is the opinion of the author.
Anyone who has been around the FIRE, leanfire, FI blogosphere, podcasts and book tours know the demographic is heavily invested in index funds and for good reason. Active management’s record tends to be unflattering compared to index peers and with a heavier expense ratio for opportunity to enjoy underperformance.
People serious about building wealth as quickly as possible learn the index fund trick early on. But there are times when index funds are not an option.
Back in the 1990s I was a securities broker with H.D. Vest Financial Services down in Dallas as my broker/dealer. Broker/dealers have an obligation to monitor their brokers so they require all investments of brokers placed though the broker/dealer. Back then it meant actively managed funds only and the expense ratios were a heck of a lot higher back then. There was only one redeeming grace in the deal: all mutual fund trades were commission free with the exception of 12(b)1 fees which generally were 25 basis points of the account’s value. In a way all mutual funds looked like no-load funds for me.
My net worth grew significantly slower during my tenure with Vest. Actively managed funds with heavy fees caused underperformance. My choices were also limited. The worst part is the rule extended to my other businesses and immediate family. Mrs. Accountant and the girls couldn’t invest elsewhere either. Vest even wanted to know where I had money in the bank and a list of all income properties and loans. It was a pain in the tail. Now you know another reason why the dream of schlepping securities wore off fast.
Normal People with Abnormal Choices
Stock brokers aren’t the only people with restricted investment choices. Work retirement plans hold a large percentage of all investable funds in most households. 401(k)s and other work retirement plans are notorious for limited choices. The choices are frequently laden with fees driving down performance.
Matching and the ease of regular investing make work retirement plans the best options even when the choices are bad. I’m asked to help clients make the best choice in their 401(k) more than any other request. Most people are clueless to the jargon used to help employees invest their contributions and employer matching wisely.
In my stock broker days my investments were exclusively growth & income funds. Before I knew about index funds front-brain I already knew a basket of successful growing companies throwing off an increasing dividend was a solid decision. The advantage I had was the large basket to choose from. I had my pick of thousands of funds so I had options, even if they were limited to actively managed funds.
Now we need to learn how to pick the best investment from a limited pool. The right choice in your 401(k) could shave years needed to retire and add tens of thousands of dollars to your account value.
Needle in a Haystack
Employers offer more retirement plan options than ever before to limit their liability. However, most employers aren’t licensed to give financial advice so they steer clear. Large employers may bring in an investment advisor, but these advisors may not have your best interest at heart and they may not have the time to know you well enough to give quality advice.
Your best defense is knowledge. Certain choices tend to better than others. Specialized funds are almost always the worst choice as they usually have higher fees and are not broadly diversified. Sector funds are a good example. I know of no reason anyone would want a gold fund in their 401(k) portfolio.
International and aggressive growth funds also tend to have higher fees. They can outperform, but they still have a higher mountain to climb to offset the higher fees. All else equal, the lower a fund’s fees the better the long-term results.
Realistically there are only a few acceptable choices for most 401(k) investments. Money markets are out because you have no chance of growing your nest egg. Bond funds are a poor choice in a low interest rate environment and only a small percentage of the portfolio should be in bonds if you are approaching retirement and rates justify a modest investment. Company stock is not diversified and if your employer does poorly your job and retirement are both at risk. Insurance products are almost always the worst of all choices. That leaves broad based funds.
Acceptable choices (in this accountant’s mind) include: growth & income, growth and international or world funds. It is my opinion the largest investment in most 401(k) portfolios should be a growth & income fund when an S&P 500 index or total market index fund isn’t available. Growth & income funds will be the closest choice to an S&P 500 index fund and G&I funds tend to have lower expense ratios than other actively managed funds.
I’m content with one investment in a 401(k). A G&I fund is a diversified choice, grabbing a large slice of large growing companies. But it looks too barren to be correct so people want more. More isn’t always better.
Growth funds are similar to G&I funds with the exception that they can hold non-dividend paying stocks. Amazon is a large growing company that doesn’t pay a dividend. A growth fund can own Amazon; a G&I fund generally cannot.
You may also wish to have international exposure. BP (British Petroleum) is more likely to be in a world or international fund. (Some G&I funds may hold BP.) Toyota is another example. International funds have higher fees due to higher trading costs and travel expenses for the active managers.
G&I funds have the lowest expense ratio of my group followed by growth funds. Fees play such a large role in long-term performance that I have an allergic reaction to more than 10% or so of a 401(k) in an international fund.
If you can’t stand a simple G&I fund in your 401(k) there are a few mixes I approve of:
70% G&I; 20% growth: 10% international, or
80% G&I; 10% growth; 10% international, or
60% G&I; 25% growth; 15% international
Of course you need to modify to your personal situation. (I have to say that for liability reasons. Personally, I can’t think of a better mix than the first choice I offered unless index funds are an option.)
A Plethora of Choices
Studies have shown more choices aren’t always better. If you have a dozen choices in your 401(k) you are more likely to take advantage of the 401(k) than if it had 20 choices. The more choices added might reduce employer liability, but it also discourages employees from taking advantage of the 401(k) due to the apparent overwhelming nature of setting up the account.
I’ve seen this first hand in my office. Some employer retirement plans offer a small number of choices, but some come to a rabbit hunt with a bazooka! A hundred choices aren’t needed to offer employees quality choices!
When the stack of papers to sign up for a 401(k) plan exceeds an inch employees are lost. Even I need to spend time digging through the papers before providing reasonable options. Here is what I look for when reviewing employer retirement plan options.
First, most choices are junk. I dump all the specialty funds and insurance products. I’ve yet to see an insurance company fund outperform. The gold and bitcoin funds are removed from the list, too.
Next I separate my choices by investment house. I like Vanguard and Fidelity. If I’m unfamiliar with the investment house, but like the fund option I need to dig deeper. I want to feel comfortable with the investment house as well as the mutual fund.
Then I separate further into categories. I pray for at least one reasonable growth & income fund in the lot. If not, I have to settle for a growth fund.
Last, I review expense ratios. Once again, the lower the fees the higher the chance the fund will perform better. The change in the total stock market value is reflected in all investor accounts, minus fees. Unless you can prove you can outsmart the market, fees are a good determinant of return comparable to the overall market (peers). (Don’t even start with me. Even the pros can’t beat the market consistently.)
From my list I usually pick the fund with the lowest expense ratio with attention paid toward which investment house runs the fund.
The Final Choice
Employer retirement plans are often the best tool a person has to accumulate significant wealth. Many employers match contributions at some level. The money is tied up so it is difficult to withdraw; this prevents impulse decisions from ruining your plans. Employers are providing more choices than ever. This is a double edged sword. Move past the psychological deer-in-the-headlights response to a large number of options and hone the list to a workable few choices and then make the choice! Employer retirement plans also make it super easy to invest on a consistent and regular basis, the true foundation of any retirement plan.
Lack of an index fund as an option is no excuse to not invest in an employer retirement plan. Many people face the same problem. I did back in the 1990s and made the best of it. My current net worth would be well into the seven figures lower if I took a pass when I sold securities because of restrictions. The bank would have been a much worse choice.
Of course, you need to modify my suggestions to your personal situation. I think you will find the best choice for you will be very similar to what I propose. No choice is the absolute worst choice! Without investing you will never reach your retirement goals or financial independence!
It’s your life. You can get serious with whatever choices you have or work forever.
Wealth Building Resources
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Worthy Financial offers a flat 5% on their investment. You can read my review here.
Where to Invest Your Money When the Stock Market is Overpriced | The Wealthy Accountant
Thursday 20th of September 2018
[…] If your temperament doesn’t handle the market well at these levels there are options. First, pay off debt. You can’t lose retiring liabilities. The car and credit cards must be paid in full. The mortgage is always a tough call. (Stay tuned for an upcoming post on paying off a low interest rate mortgage versus keeping the mortgage and investing the funds for a higher return.) I feel paying off the mortgage makes sense for most people. “Safe” investments don’t pay as much which makes them less safe than perceived. […]
Elliott
Thursday 10th of May 2018
I'm curious what you think of taking advantage of asset location. My current total portfolio is almost identical to your 70 g&I, 20 growth, 10 international. However, my 401k has no international funds in it. Why, all of my international funds are I my taxable accounts so I can deduct the foreign taxes paid.
Keith Taxguy
Thursday 10th of May 2018
My personal accounts, qualified and non-qualified, are invested 70% S&P 500 index and 30% international all at Vanguard, Elliott. I don't worry much about tax issues because index funds are tax efficient by design. Corporations pay a variety of taxes. I don't worry about the foreign tax credit. (C corporations do have a play here which would take too much space to cover without a new post.) I manually rebalance every year or so. Taxes are a consideration when doing so. I understand what you are trying to accomplish. Either readers will understand the tax issue or they won't. Illustrations would take an entire blog post. Taxes are always a consideration, but I keep it in perspective.
JK
Thursday 10th of May 2018
FYI - your link at the bottom is for "Personal Finance" and it should be "Personal Capital" I think. Just wanted to make you aware. Love the blog. Keep writing great stuff!
Keith Taxguy
Thursday 10th of May 2018
Thanks for pointing it out. Sometimes the words get in the head and they don't leave.
Kenneth
Thursday 10th of May 2018
"Specialized funds are almost always the worst choice". Uhhh, Keith, I very much disagree with you here. Not gold, but Technology is the right specialized fund! VGT is the ETF for Vanguard's Information Technology Fund. Here is a snapshot chart showing it outperformed the S&P 500 by two to one over the last 4 years:
https://www.tradingview.com/x/N8tC7TIR/
Keith Taxguy
Thursday 10th of May 2018
Kenneth, each person needs to modify my suggestion to their personal needs.Technology is outperforming now, but most investors will not want to research deep enough to know if technology will under-perform the next several years. Bitcoin also outperformed recently, but I'd never begin to suggest it to a broad audience. My goal was to illustrate alternatives to investors who prefer index fund investments. I wanted to keep it a family-friendly post. Now look what you've done? (Yes, you should smile at that last remark.)
Kenneth
Thursday 10th of May 2018
Oh and this is not advice for anyone, I'm just saying have a look around. It might make sense to some people, me included, that technology is where the growth is.
Andy
Thursday 10th of May 2018
My wife is lucky enough to have Blackrock index funds in her 401k. We use the Blackrock index funds to mimic the Vanguard Total World Index. We own the Vanguard Total World Index fund in our IRA's and brokerage account at Vanguard. We believe in world market weight. Other allocations are home bias and speculation. We buy the haystack.
Her 401k index funds don't have tickers. They're called collective investment trusts. They're managed by Blackrock institutional trust company. The expense ratios for these funds are super low. We're lucky.
Keith Taxguy
Thursday 10th of May 2018
Blackrock is a solid choice. I like your analogy of buying the haystack.