Most people wouldn't dream of going year after year without ever seeing a dentist for a checkup, whether or not they have any signs of trouble with their teeth. Yet they'll leave thousands of dollars sitting in their retirement accounts for decades without so much as looking to see how well those investments are doing. It's vital that you check on the status of your retirement investments at least once a year, even if you haven't noticed any obvious problems.
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Changing priorities call for changing investments
Early on in your career, the top retirement priority is typically to get as high of a return as possible on your savings. If you've got several decades to go before you actually need to tap into that money, you have the luxury of taking some risks in return for getting bigger rewards. Thus, stocks are the best choice for young workers choosing investments for their retirement contributions. But as you get older and start approaching the big day, your risk tolerance will drop. If a 30-year-old chooses a retirement portfolio that drops in value by 25% the next year, it's annoying, but there's plenty of time for the portfolio to recover its value and then some. If a 60-year-old has a 25% drop in his retirement accounts' value, that's a bit more than an annoyance.
It's important to shift your retirement investments over to less risky assets as you approach retirement, which brings us back to the need for annual checkups. Part of your checkup process will be shifting how you allocate your contributions between stocks and the less volatile and less risky bonds. A formula that usually works well is to subtract your age from 110, and use that result as the percentage of your retirement investments that should be in stocks. For example, if you're 30, then 110 minus your age would be 80 -- so 80% of your contributions should go into buying stocks with the remainder in bonds.
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Rebalancing reduces risk
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Just because you set your contributions to the right percentages of stocks versus bonds doesn't mean that your actual investment balances in your retirement accounts will match those desired percentages. This is a result of something that's normally highly desirable in an investment portfolio: namely, diversification. Diversification means spreading your money out over several very different types of investments, so that if one type of investment performs poorly, it's likely that the others (being so different from the first investment) will be holding steady or even going up. Of course, the fact that your different investments will be behaving differently means that the changes in value between those investments will also change the percentage of each type of investment in your portfolio. For example, let's say that you have set your contributions at 80% stocks and 20% bonds. Over the last year, the stock market has thrived but bonds have declined in value. When you take a look at your portfolio a year later, it'll probably be something like 82% stocks and 18% bonds because the stock investments have become more valuable and the bond investments have lost money. And of course, since you're a year older, you'd actually want only 79% of your investments in stocks and 21% in bonds. Fortunately, this is easy to fix: simply sell a little bit of stock and put that money in bonds instead, and you'll have perfect allocations once more.
Checking for hidden costs
The investments you originally chose for your retirement accounts may have been the best possible investments at the time, but within a few years it's possible that they are no longer a good choice for you. Unless you're a dedicated investor and stock picker, retirement accounts are best placed in either a target date fund or an index stock fund paired with an index bond fund. But the funds you chose at the beginning may not be performing as well as you expected, or the fund managers may have chosen to hike up the fees on their funds.
High fees can have a brutal effect on your returns, to the point where a low fee fund with a relatively low return may actually grow in value faster than a high fee fund with a somewhat higher return. That's one reason why index funds are such a great choice: fees on an index fund are typically far lower than fees for an actively managed fund.
For example, let's say you have two investment options: an index fund returning on average 7% per year with fees of 0.10%, or an actively managed fund returning 7.5% per year with fees of 1%. Since the fees come out of your returns, in order to figure out your actual return, you'd take the return percentage and subtract the fee percentage. So the index fund is actually returning 7%-0.10%, or 6.9%. The actively managed fund is returning 7.5%-1%, or 6.5%. Even though the actively managed fund seems to be doing better on paper, it's actually performing worse than the index fund in your portfolio. That's why it's important to check your fund prospectuses every year to see what's been happening with their fees. If fees have gone up, it's time to shop around and see if you can find a similar fund that's charging less.
Wrapping up the checkup
So you've changed your contribution allocations, rebalanced your portfolio investments, and confirmed that there've been no fee hikes in your chosen funds. At this point, having browsed through the investment options to see what's available for you, it's tempting to swap out your current investments with new ones just to shake things up a bit. However, lots of trading will likely cost you money in the long run. Buying a good investment and holding it for the long term has been proven to produce the best results over time versus periodically swapping out investments or (even worse) trying to time the market. If you really want to get experimental, set aside no more than 10% of your retirement portfolio for fooling around with different types of investments and leave the other 90% in the safe, proven ones. That way, you can have some fun and maybe even make a little extra money without putting the bulk of your retirement savings at risk.
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