How to Pick the Best Mutual Fund for Your IRA or 401(K)

If you are a participant in a typical 401(k) plan, you face a list of 18 mutual funds to choose from.   If you set up your own IRA plan, the list grows to over 4000 funds in the universe.  Most people don’t have the foggiest notion of which fund choice is the best for them.  The answer is actually quite simple, if you understand a few essential truths.

Before you get to the mutual fund choice, you may have an even more important decision to make. It involves the kind of IRA you pick.  The Roth IRA is an infinitely better choice than the traditional IRA.  You forego a tax deduction in year one but you avoid paying ordinary income taxes every year you withdraw money during your retirement years when the amounts you withdraw are greater and the tax rate you pay is likely to be higher than during that first year (the government ultimately will be forced to raise rates to pay for social security and the interest on the federal debt).

The Roth IRA is such a good deal for you and such a bad deal for the government that they severely limit how much you can contribute ($5500 a year or $6500 if you are over 50), and if you make over $127,000 as a single or $188,000 as a couple, you can’t contribute at all.  If you qualify, choosing a Roth IRA over a traditional IRA is a no-brainer.  After five years and you reach 59 ½, there are no restrictions when (and if) you withdraw money while your nest egg continues to grow tax-free, including the dividends.

Astonishingly, in spite of the considerable advantages of Roth IRA’s, only 2% of all IRA investments are in Roth IRAs.  That is an unbelievable number to me. I just don’t understand how so many millions of Americans have made the absolutely wrong choice for themselves.  Of course, they also drop millions of dollars every day at the casinos, knowing full well that the house will win every time over the long run.  So I guess we should not expect them to be very smart about their IRA choice, either.  But it is a sad fact for me.

If your company’s 401(k) plan does not offer a Roth IRA alternative, speak to HR and ask them to get it in there.  Your fellow employees, and you, deserve it.

Once you have selected the Roth IRA alternative (if it indeed is a choice for you), you face the mutual fund choice challenge.  Why do you suppose that the average 401(k) plan has 18 choices?  That seems to be a fairly large number to choose from.  Surely, your company could figure out the three or four best choices out there and restrict your choices to those.  That would be offering a real service to anyone who lacks the financial education or experience to make that kind of important choice for their future livelihood.

Sadly, apparently the biggest reason that many companies offer a large number of mutual fund choices in their 401(k) plan is to avoid a lawsuit.  Class action suits have (successfully) been brought by employees of many companies against their employees because mutual fund choices were more beneficial to the mutual fund companies and just awful for the employees.  The courts have sided with the companies when a large number of mutual fund choices were offered (“it was the employees who decided to pick those bad ones – they had a better choice but did not take it” was the reasoning).

In a perfectly just world, the companies would also be required to provide more information to employees as to which the best choices would be for their employees. But as we all know, our world is far from perfect.

Fortunately, there is a best choice, and it is definitely not the most popular one.  The most popular choice is the target-date funds.  They make intuitively good sense.  You know the approximate year when you expect to retire, and you just select that date fund.  More than 40% of 401(k) participants make that choice (and that number is projected to grow to 50% by 2020). 

The sad fact is that there is not a single 5-year period ever when target-date funds have outperformed a low-cost broad-based index fund.  The only time when they have come close is when the stock market has crashed (since some of the target-date money is in fixed-income instruments, they do not fall quite as much as the overall market in market-crash years).  Over the last 5 years, target-date funds have lagged behind the market by 22% - 47% depending on the target date – truly monumental losses for all target-date fund owners.

Target-date funds underperform for two important reasons.  First, expense ratios (management fees) are higher, usually about three times as much as most index funds.  It doesn’t take a smart Wall Street MBA to pick the stocks in an index fund (rather, a fixed selection of stocks is blindly followed).  Consequently, the management fee can be much less for the index fund.

 Second, trading costs are usually two or three times as great in equity funds (especially target-date funds) compared to passive index funds.  The turnover rate can be 50% to 100% for many equity funds, running up considerable commission and trading costs that are passed on to participants (and generally not revealed to them). 

Even worse, this excessive turnover is subject to the completely hidden costs of high frequency trading which skims off millions of dollars for Wall Street every single trading day.  The big losers from high frequency trading are the owners of non-index equity mutual funds.

I have written a Kindle book that explores this entire issue in far more detail and tells you specifically exactly which fund you should choose for your 401(k) plan.  It is designed to be read in an hour (although two hours is probably a better time to allot).  I have immodestly called the book The Best Little Book on investing in an IRA or 401(k), Period!  It is yours for only $5.99.  It could change everything you ever knew or were told about retirement investing.  If you have a single target-date or other non-index mutual fund in your investment portfolio, this small investment of your time and money could save you thousands of dollars over your lifetime.  Get it now, here.

The book includes one suggestion that is highly unlikely to have been disclosed to you by HR and is almost guaranteed to save you thousands in tax savings when you retire.  Why would any rational 401(k) participant not plunk down $5.99 to discover it?  Maybe because they are at the casino where they think they are more likely to come home with more money than they started out with.

Sincerely,

Terry