Understanding How Your Money Will Be Invested
When you make a contribution to a retirement fund, you are actually making an investment in a limited number of funds available through your employer. To understand how your money will be invested, you need to know some concepts.
1. Stock fund – A stock fund represents an investment in the stocks of a collection of companies. The companies are selected by a fund manager. Various mutual funds have different investment objections. Funds can be specialized by
- Industrial sector
- Domestic or international
2. Bond funds – These funds invest in fixed income securities. A bond is essentially a debt that carries with it a specific interest rate. When you invest in a bond fund, you are investing in
- Government bonds (federal, state, local)
- Mortgage bonds
- Corporate bonds
Bonds carry different levels of risks. The riskier the bond, the higher the interest rate that will be paid.
3. Money Market Funds – These funds are short term fixed income securities. Money market funds have very little risk, but they also don’t have much opportunity for growth in value.
4. Exchange Trades Funds (ETF’s) – These are funds that operate much like stock funds or bond funds but they are traded on stock exchanges. ETF’s have an advantage of having low operating costs and stock like features. These are relatively new and not all employers will have these as an investment option.
When you sign your employment agreement, you will be asked to make a selection among different types of funds. In order to make these decisions you need to understand some basic concepts
- Management fee – This is the fee that the fund manager changes to operate the fund. You will want to invest in a fund that has a low management fee.
- Expense ratio – The expense ratio is the expense of running the fund divided by the asset value of the fund. Expense ratios should be less than 1% but in many cases you can find expense ratios of .5% or less.
- Net asset value (NAV) – The NAV is the current value of the assets held by the fund minus the liabilities. Generally the NAV is described based on the value per share invested. These share prices are published every day.
- Style box – This is a graphic produced by the Morning Star organization. See the attachment. Go to Morningstar.com and you can check out the focus of the investment.
▬ Value – represents investments that are undervalued by the market and offer potential for growth in stock value
▬ Growth – these are investments in securities that have the potential for significant growth
▬ Blend – these are investments in stocks that are both value and growth.
▬ Large cap – these are huge corporations whose value is above 10 billion.
▬ Small cap – these are corporations whose stock value is between $300 million and 2 billion
- Past performance – on the Morningstar website, you can fund charts that show the gain in fund value in different time increments. You should look at 3,5, and 10 year performance. Once you have looked at the gains, compare this value to the index that the fund is focused on. For example a fund you are considering may a return of 8% which seems good, but the index representing this fund type may be 10%. That means the fund is under performing the broader market.
- Fund ratings – Morningstar uses a five star rating system to evaluate funds. The ratings are peer group comparisons
***** Top 10% of the funds in their peer group
**** Funds in the 77.5%-90% in their peer group
*** Funds in the 32.5%-77.5% in their peer group
** Funds in the 10%-32% in their peer group
* Funds in the lowest 10% of their peer group
There is a lot to consider in deciding on the funds you want to select for your account. When you accept a job offer, you need to request the fund list that your future employer makes available to you. Then you need to go to the Morningstar website to analyze the funds you want to select.
For college graduates, a wise allocation strategy would be the following
80%-90% stock funds
105-20% bond funds
Those with more tolerance for risk are more likely to look at a greater allocation for growth funds than value funds. Typically larger capitalization funds have less risk than mid and lower capitalization funds. You will have to determine your own tolerance of risk.