Alright, now it’s time to get down to the nitty gritty. You’ve decided on an allocation and you’ve decided on a location. Now for the big question: what funds do you actually buy? As it turns out, this part is actually simpler than you might think. There are two main rules:
#1: Follow your allocation. This means avoiding funds that are mixes of different asset classes, which includes most actively-managed funds, since they almost always contain some amount of cash.
#2: Find the lowest expense ratio possible. Forget Morningstar ratings; within a given asset class, expense ratio is the best predictor of fund performance. Now, this is simultaneously intuitive and counter-intuitive — one would expect a cheaper investment to be a better bargain, but at the same time, one would expect someone who charges more to give you more for your money. That’s certainly what expensive funds would like you to believe, but the research — including Morningstar’s own! — doesn’t bear that out.
With those two rules in mind, let’s take a look at 401(k)’s and IRA’s.
With 401(k)’s (and 529’s), rule #1 is generally enough to suffice: you rarely have more than one fund per asset class, which makes the choice easy. However, sometimes there’s no direct match, in which case you just do the best you can. Here’s a list of funds you might swap out a given asset class for, in order of preference:
- Large Cap -> Total US Stock -> Total World Stock
- Large Cap Value -> Large Cap -> Total US Stock -> Total World Stock
- Small Cap -> Total US Stock -> Large Cap Value -> Large Cap -> Total World Stock
- Small Cap Value -> Small Cap -> Total US Stock Index -> Large Cap Value -> Large Cap -> Total World Stock
- REIT -> Large Cap -> Total US Stock -> Total World Stock
- International Developed -> Total Ex-US Stock -> International Large Cap -> Total World Stock
- International Small-Cap -> International Developed -> Total Ex-US Stock -> International Large Cap -> Total World Stock
- International Emerging Markets -> International Small-Cap -> International Developed -> Total Ex-US Stock -> International Large Cap -> Total World Stock
- Intermediate-Term Bond -> Total US Bond
- Short-Term Bond -> Intermediate-Term Bond -> Total US Bond
- Inflation-protected Bond -> Short-Term Bond -> Intermediate-Term Bond -> Total US Bond
Now, with an IRA, your choices are much, much broader, bordering on overwhelming. However, given that the ideal per the above rules is (a) a “pure” mutual fund, and (b) an inexpensive one, the choice becomes clear: Vanguard index funds. You can easily find an index fund that matches any of the given categories above, and it is virtually guaranteed to have the lowest expense ratio in its class. Also, you can avoid brokerage fees by opening your IRA with Vanguard itself. The only caveat is that Vanguard funds often have a minimum ($3,000 is the most common). If you have less than this, you can substitute funds as per above; for example, you could combine all of your stocks into Total World Stock and all your bonds into Total US Bond.
(Sounds like an advertisement, I know. But Vanguard doesn’t know me from Adam. I just like their funds.)
That’s it — you’re done! Once you’ve come up with your allocation, all you have to do is rebalance periodically to stick with your target (and update your target as circumstances change). More on that in a future post.
In the meantime, if there’s a related topic you’d like me to go over in detail, let me know in the comments!