Roth IRA

I wrote an email an few years ago to send to some friends on setting up retirement accounts, and I wanted to republish it here. I've cut some of the language out, but the substance is all here, and I also added a bunch of inline links. Note that this was written in 2005, so any of the projections are current as of them. Looks like I got the real estate market right, even if I was a few years early. Also, note that all my friends are single, so all the advice is for a single person. If you are married, there is nothing I can do to help. You got yourself into that mess.

Here is what I have put together for a few of my buddies and my ex as far as getting started, which is hopefully with Vanguard. I've added the specific funds I think you should look at for what I have described below. What I am trying to set you up with below is your "base" retirement fund - this would be a blend across multiple investments that would have growth potential but would also be well diversified. I will say that I have the fund I describe below in my 401(k), but I have a much more aggressive portfolio within my Roth IRA which I developed based on where I think the market will go and is more weighted for long term growth as I have a long time before I plan on taking the money out.

what im going to do is write a lot of stuff here, then try to summarize it at the end. all you need to do is keep the email and you can refer back to it whenever you need to, you dont need to try to understand everything right away.

I will try to focus on asset allocation - how to split your money up over different types of stock and bond funds to diversify your portfolio. most of the information and suggestions i am giving you comes from reading the intelligent investor by ben graham, updated in 2004. i have tweaked the advice in that book a bit from different pieces of information from the washington post, business week, and the wall street journal. additionally, please remember that i am setting up a portfolio that is long term in nature. currently, real estate funds are, in my opinion, overvalued, and energy funds are killing. i will be recommending, however, that you invest in the real estate fund, because while there might be a correction in the short term, in the long term it will help balance your portfolio. i am not trying to "time the market," i am giving you advice for what has been a historically successful long term strategy.

the current rules for putting money into the two funds are as follows. $14,000 can be put into your 401k this year, then $15,000 next year (for 2008, its $15,500). this is the choice of the irs and the government, so keep checking year to year what the maximum contribution amount is. your roth ira has a maximum donation of $4,000 this year (for 2008, its $5,000). same deal here, this max will change, so check once every few years. a few things with the roth. currently, if you are making more than $90,000 a year, the amount you can contribute to a roth is decreased, and then phased out completely at $110,000 (for 2008, its $101,000 to $116,000). this is done because of the tax effects of the distributions with the roth, but you don't need to worry about any of that. additionally, with the roth there is a provision that you can take a one time withdrawal, tax and penalty free, of $10,000 to purchase a house, if the money has been in your ira for 5 years. i do not advise that you take this money out of your retirement funds, rather if you plan on buying a house start to put money into the roth specifically to take advantage of this clause, preferably in a short to intermediate term bond index fund.

ok, so thats the 401k vs the roth. now lets talk about asset allocation. you are getting a great head start on your retirement by starting now for two reasons. one is with a longer time horizon until retirement, you can take more "risk" because you know that over time the short term fluctuation will come back and work in your favor. second, by reinvesting all interest and capital gains from a fund, you receive the maximum benefit of compounding. the bulk of your retirement money will be made before the age of 35 (as all this money will compound over the next 30 years) so you have 12 years to take advantage of this. what does this mean for your portfolio? you should invest much more heavily in stocks (a riskier asset) than bonds for the first 20 - 30 years. the stock market has historically returned an average of 10.47% per year (on a nominal, not real basis), based on the s&p 500 Composite Stock Price Index from 1965 through 2004, compared to bond rates of around 8%. your portfolio will therefore be structured more heavily towards stocks to start. every 5 to 10 years, you will then adjust your allocations to better match the amount of time until retirement, from stocks towards bonds. a good pictorial example of this is of the vanguard target retirement funds.

k, thats the background. now for action. i will give you approximate amounts that you should invest in each asset class, then you need to decide what you want to do.

so, here is what i suggest:

55-65% domestic stock index fund (the fund i hold is Vanguard Institutional Index Fund Institutional Plus Shares)
20-30% international stock index fund (i hold Vanguard Total International Stock Index Fund)
5-15% long term bond fund (i hold Vanguard Long-Term Bond Index Fund)
5-15% reit (real estate investment trust) index fund (i hold Vanguard REIT Index Fund Investor Shares)

a few things to remember. one - look at the fees on each fund! very, very few managers can beat the market year after year over a long period of time, and to truly beat the market, they need to achieve a higher rate of return on the market plus the fees charged. for example, if the market returned 10% and a manager charged 2% in fees, then the manager would need to realize greater than a 12% gain to truly beat the market. over time this wont happen. so try to
stick to index funds and other funds with low low expense ratios. vanguard has some of the best rates in the business, so you can look at similar funds on that site to see what kind of fees you would expect to pay. so try to stick to index funds with low low expense ratios. second, for the bond fund, you want to get the highest rate of return possible, which means the longest period of time. a lot of funds offer an intermediate term total bond market index fund, which returns around 2% less than a similar long term fund. even with a slightly higher expense ratio, you will still realize higher returns with the long term fund, so make sure you pay attention to that as well.

ok, i think this essay is long enough. to summarize:

you have two choices, build your own fund, or invest 100% in a Vanguard fund of funds. if you build your own fund, aim for the following allocation:

55-65% domestic stock fund
20-30% international stock fund
5-15% real estate fund (preferably a reit index fund)
5-15% long term bond fund

if you want to let vanguard do the work, put 100% of your moneyin the following fund:

vanguard target retirement 2050 fund (vfifx)

ask these questions:
1. what are the fees on each of the funds i will be adding to my portfolio?
1b. (compare yourself) what are the fees on similar vanguard funds?
2. can i be getting a better return with a fund that invests in similar assets (ex. long term bond fund vs total market bond fund)
3. why the hell did glenn write an essay this long?
4. what do i need to do to change my portfolio or add investments? - for later, but good to ask now

thats pretty much it. the summary was much shorter. maybe i should have stuck with that. hopefully you got all the way down here, probably you didnt, i know i wouldnt be able to. if you have any questions (which i would assume you would because i am not going to reread this for things i didnt explain well) please post a comment and ask.