Know the Pros and Cons of Different Retirement Investment Vehicles

Index funds are one of the most underrated asset classes out there and don’t receive the attention they deserve. Because an index fund is designed to mimic the performance of a benchmark index – most commonly the S&P 500 Index – it’s difficult to actually underperform the market average. Conversely, it also means that they generally don’t outperform the broader averages either. But if the historical average return of the S&P 500 Index is exactly what you are aiming for in your retirement portfolio, an index fund is a strong number-one pick.

These funds are not actively managed since stock selection is simply the same stocks that the index fund contains. That means that they typically come with extremely low expense ratios – a significant benefit for investors with an investment horizon of 10 or more years. However, they do come with a rather large downside: there’s no active hedging by management which means that sometimes these funds could be more volatile than the overall market. That can translate into large up and down swings.

Investors close to retirement should avoid index funds since the increased volatility could result in a large loss at a critical time before income withdrawals begin. Index funds are best suited for investors with a longer time horizon and a larger appetite for risk since they have plenty of time to ride out volatile years before they need to start making withdrawals.

Mutual funds are the bread and butter of nearly every investor’s retirement account – and for good reason. Thanks to an active portfolio management style, these investment vehicles give investors a professional’s expertise when it comes to asset selection processes. That tends to make mutual funds less volatile than the broader market indexes, on average. It can also lead to consistent outperformance of those indexes given the right portfolio management team. However, one needs to factor in the expenses of mutual funds, which are typically higher compared to index funds.

Each mutual fund is a breadbasket of individual asset holdings, which means investors can achieve diversification with just a few, or even just one, mutual fund. The plethora of fund types and asset classes means that investors have a lot of options as to what to pick. For retirement account purposes, you’ll want to make sure that you have the proper mix of stocks and bonds – something that can be achieved with a single mutual fund in some cases.

Management teams tend to be one of the most important factors when choosing a fund. Some mutual funds have a long track record of consistent outperformance, while others continually lag behind.

Investors who are looking for higher returns in their retirement accounts, but still need risk management techniques may prefer mutual funds.

Target-Date Funds are gaining in popularity quickly. The promise of automatic asset allocation over time offers investors a truly hands-free approach to retirement investing.

Target-Date Funds (TDFs) are usually classified by their target retirement date. As an example, let’s look at PIMCO’s RealPath Blend 2045 A (PVQAX). Right now, the asset allocation in the fund’s holdings are largely geared towards higher-yielding, more volatile investments such as stocks.
As time moves forward and gets closer to the 2045 target date, the fund’s asset allocation will change to favor more conservative, income-producing assets like bonds.

One of the biggest drawbacks to TDFs is the lack of risk appetite customization. The asset allocation percentages are all done in-house, which means a TDF may be more or less conservative than investors want. It also tends to make these types of fund underperform market averages since they tend towards a conservative investment style rather than aggressive.

Investors concerned about retirement or who don’t have the time to monitor their investment accounts may want to consider a TDF in their portfolios.

Investors who like a bit more hands-on management of their retirement accounts may prefer to pick individual stocks rather than rely on portfolio managers or market index performance. The possibility of beating the market along with a lack of overhead expense fees is appealing to aggressive investors who like trading in the market.

The risk/reward of adding stocks to a retirement account is high, which means that investors nearing retirement may want to choose mutual funds or bond investments instead. One thing to keep in mind is that many 401(k)s and IRA have restrictions on what stocks can actually be held in a portfolio as well.

Below is a quick rundown of each investment vehicle. Note that selected examples are meant to be representative of that investment vehicle class.

Data as of February 3, 2022

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One thing to keep in mind as you plan your retirement investment portfolio is that mixing up two or more of the above options is perfectly acceptable. Adding diversity by including more than one type of investment vehicle can help reduce portfolio risk and volatility. For a retirement portfolio that contains individual stocks, you’ll want to have at least 5 to 10 different holdings in order to maintain proper diversification.

Once you have your investment accounts ready to be funded, make sure you’ve taken the time to think about what your goals are. You’ll want to at least know what risk tolerance you have and a general idea of what kind of returns you’ll need to achieve in order to reach your retirement goals. Always keep in mind that investment accounts can always be moved around and adjusted as well, so don’t be afraid to try a few different methods to find what works best for you.

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