When most people ask about setting up their 401k and which mutual funds to pick the easiest answer is to choose index funds. Since most people don’t actively manage their retirement accounts (most people just direct deposit and forget about it, they aren’t interested in following the ups and downs of the stock market) this is probably some of the best advice an average joe can receive.
Yes, it is true there are many mutual funds that can outperform mutual funds.
However, if you aren’t paying attention the churn (buying and selling stocks that is) can have all sorts of fees and interest associated that aren’t transparent by just looking at the annual rate of return.
In addition as fund managers can change, so can performance. Index funds tend to track with the market (which for the most part always trends upwards over time) and have very little churn (so fees and hidden taxes don’t eat away at your gains).
When ever you think about an investment it is super important to take fees into consideration because they can have a big impact on your returns.
Take for example my recent ShareBuilder IRA…..
Even though my investments are relatively small compared to many people (you have to start somewhere right?) I have been trying to do lots of research and make careful selections of each stock that I want. As I said previously, I opened a ShareBuilder account for my new IRA. I have elected to do the automatic investment plan (just like a 401k you put money in every month and it can be invested in the stock or your choosing–even if you can only own a fraction of the stock). Since I have the basic account there is a $25 yearly fee, and $4 per month commissions. This results in $48+$25 = $73 in fees every year (assuming you pick one stock per month to invest in). You can also elect to use the basic plan which charges $12 per month, or $144 year, but you can pick 6 stocks every month–which gives you a lot more diversification. Since I am only investing $5000 per year, $144 is only about 3% of total gains. Although, if you have a regular ShareBuilder account (which also works out to $144/year) the $25 fee is waived (you still have the $48 in purchase commissions if you deposit into the account monthly). While I really want a Foliofn account at $29 per month ($348/year) ($209 per year if you subscribe to their yearly plan) it is a bit more than I want to spend on fees (but like ShareBuilder it allows you to invest in stocks in dollar amounts, but does allow unlimited free trades twice daily)–although perhaps it is better than ShareBuilder which charges you $9.95 to sell any investments.
Thinking through all these fees and how they affect your returns is more complicated than it should be!
I read somewhere that the amount you spend as overhead on your investments should be less than 2% of your total capital. That means if you are only investing $5,000, you shouldn’t spend more than $100 on investing newsletters, brokerage fees, account fees, etc. That means that even for 1 year of an IRA I am going to be over paying in fees 🙁 — now by year 2 if you contribute another $5,000 (the maximum contribution) your fees will be make a little more sense. Overall I still think ShareBuilder makes the most sense for me since I am just starting my IRA. I am considering opening a regular investment to waive the $25 annual fee on my IRA and invest a little bit of money with low commissions.
But all these fees certainly are certainly having an influence on my decisions!
Wherever you choose to invest, whether it is your employer’s 401k plan or your own little brokerage account, make sure you do research and factor in the fees associated with your investment. This will have an impact on your gains, and depending on how actively you manage your portfolio, should influence your decision about which vehicle makes sense for you. And for those of you that know very little about finance, I would still suggest index funds as a great start for your investments.