Saving enough to finance your entire retirement requires a major commitment of your disposable income, so it's no easy task. Forunately, you can put your money into investments that will generate more money for you, thereby reducing the amount you need to squeeze out of your paycheck. But if you're not getting good returns on your retirement investments, you're missing out on that advantage and selling your future short.
The power of compounding
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Let's say you plug some numbers into a retirement calculator and decide that you need $1 million to finance your retirement. That doesn't mean you have to personally contribute $1 million to a retirement; it means you have to save enough so that the money will turn into $1 million by the time you're ready to retire. Once you factor in the return on your investments and your employer's matching 401(k) contributions, you'll probably find you only need to save a fraction of $1 million -- especially if you start early.
That's largely because of the power of compounding: As your investments grow in value, you'll own an ever-larger share of each one, which means you'll reap an ever-growing share of future gains. The longer your money is invested, the more this effect snowballs. Naturally, the higher the returns you get from your investments, the faster they'll compound. That's why it's crucial to keep an eye on your 401(k) and IRA investments and make sure they're giving you decent returns.
How to spot underperforming investments
The stock market is notoriously volatile. While its long-term returns are undeniably high, the market's performance in any given year can range from tremendous gains to gut-wrenching losses. So if your 401(k) investments produce a loss in one particular year, that doesn't necessarily mean you've made bad investments; the stock market as a whole could have dropped in value, too. The one sure way to know whether your investments are underperforming is to compare their performance to that of an appropriate benchmark.
When it comes to stocks, they should ideally perform at least as well as the S&P 500 index. If they don't, consider swapping them out with investments that should keep up with the market. Practically every investing newspaper and website will tell you the one-year return for the S&P 500 is; for example, you'll find it on the Motley Fool homepage on the right-hand side. When you do your annual review of your retirement accounts, compare your stock investments' one-year returns to the one-year return for the S&P 500 and make a note of any investments that didn't meet or beat the market.
Be aware that target date funds are unlikely to produce returns as high as the S&P 500 index, because a percentage of their money will be invested in bonds, rather than stocks. Your target fund will probably be at least a couple of percentage points short even if it's doing well. However, if it's way short of the S&P 500's annual return, then look for alternatives -- especially if you're in your 20s or 30s, because most of the target fund should still be in stocks at that point. Similarly, if you've intentionally made your portfolio much more diversified than the S&P 500 in order to mitigate your risk, then you can expect somewhat lower returns. Safety comes at a price, after all.
Picking the right stock investments
There are many reasons why a fund or ETF might underperform the market; it could be due to high fees, poor investment choices from the fund manager, or the fact that you've simply chosen the wrong fund for the job (for example, a mutual fund that is designed for low volatility will inevitably produce lower returns over time than a fund that accepts a higher level of risk). An S&P 500 index fund or ETF is usually the best choice as the backbone of your retirement stock investments. If your 401(k) doesn't offer such a fund, see if it has a different broad-based index fund or ETF available. Another option is to bundle your stock and bond investments in a single target date fund. Before committing to any fund, compare its performance in recent years to the performance of the market as a whole over the same time period to see if it's done fairly well in the past. While past performance is no guarantee of future results, this will at least give you some indication of what you might expect.
Sometimes your individual investments will be doing OK, but your overall 401(k) or IRA will be producing relatively low returns. That's a sign that you may have the wrong asset allocation in your account. Asset allocation refers to how you've split your money between different types of investments -- in retirement accounts, that typically means between stocks and bonds. A good rule of thumb is to subtract your age from 110 and put that percentage of your retirement investments into stocks, with the remainder in bonds. If you're 40 years old, that means you would have 70% of your retirement investments in stocks and the other 30% in bonds. This formula will gradually shift more and more of your money into bonds and away from stocks as you age, which is exactly what you want to happen: The closer you get to retirement, the less time you'll have to recover from stock market tumbles, so reducing the stock portion of your portfolio over time protects you from such a disaster.
Don't ignore your accounts
While it's not necessary to check your retirement account balances every single day, it's wise to look them over at least once a year. That way, you'll be able to get rid of any underperforming investments and keep your money churning out the highest possible returns. Isn't that worth spending 15 minutes or so once a year?
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