The financial industry loves to sell complicated — and expensive — products, but simple is quite often the smart choice.
A recent analysis by Callan created a simple hypothetical portfolio for a 45-year-old saving for retirement. The portfolio contained only the S&P 500 stock index and the Bloomberg Barclays U.S. Aggregate bond index. Over a 10-year stretch, that boring approach delivered a higher return and less risk than a more complex portfolio holding two-dozen asset classes.
While 10 years is a short time period, and we know that past performance is not a guarantee of future performance, the data suggest that getting basic diversification right (an age-appropriate mix of stocks and bonds) is the big win.
Here’s a short cheat sheet of how to cash in on keeping your financial life simple.
• TDFs. The average target date fund (TDF) typically owns four to six different asset classes, in a mix tied to the investor’s anticipated retirement age. Not as simply as two, but pretty straightforward.
Moreover, the TDF automatically rebalances from time to time to get back to the “target” allocations for a given asset.
Nearly all 401(k)s offer TDFs, and many “default” new employees into one if they don’t choose other funds.
• Indexing. If a TDF isn’t your cup of tea, the next best approach is to focus on low-cost index funds or exchange traded funds (ETFs). Aiming to match a benchmark is undeniably the smartest way to invest. Data prove that active managers don’t produce better returns.
And active managers typically have a higher fee hurdle to overcome. The annual expense charge is typically a lot more than the annual expense ratio for index mutual funds and ETFs.
• Automate. Set up an automatic transfer from your checking account to a separate savings account that transfers money every week, two weeks or month. Once people go this route they find they can live with the transfers, and if necessary can adjust their spending.
• Term over permanent. Term life insurance is the “simple” approach, in place for a set number of years (the term), and does not have an investment component. For the vast majority of life insurance needs — protecting kids until they are ready to launch, or providing funds so a partner can keep up with payments on a mortgage — term insurance is simple and smart. It costs a fraction of permanent insurance. And you are typically better off doing your investing elsewhere.
• Income annuities over … everything else. As retirement nears, a smart strategy is to create a plan for all your fixed essential costs to be covered by guaranteed income, such as Social Security and a pension payment.
But if those income sources won’t cover your basic expenses, buying an annuity can make up the gap. Unfortunately there are many types of annuities, some very expensive and insanely complex.
Here, too, simple works great. Check out income annuities. They are a plain vanilla type of annuity where you fork over a chunk of money and then, based on your age and when the payments start — it can be immediate, or you can buy a deferred income annuity where payouts start in a few years — you are guaranteed payments for the rest of your life. No bells and whistles.