The idea behind diversification is a simple one - spread your investments out to a bunch of different industries such that if a downturn hits one, you aren’t entirely exposed. That’s the simple explanation and it’s trying to distill a more complex topic that requires a bit of explanation to fully understand. This post will have no math in it, to warn you, but it will explain some ideas that sound a lot like math.

The idea behind diversification is actually designed to maximize your returns given your level of risk. When experts advise you to spread out your investments, what they’re really advising you to do is put it in investments that have a low covariance with each other but they’re saying it in plain simple language. Covariance is a statistical measure used to calculate how closely two particular investments move with one another. A high positive covariance means that when one goes up, the other goes up just as much; a high negative covariance means that when one goes up, the other goes down just as much. You don’t want either, you want two investments that have low (positive or negative) covariances.

So, when you diversify, be sure to check the covariances of your investments because if you pick the wrong ones, your diversification strategy may not help you as much as you think.

If you wanted to retire in 40 years on $5,000 a month (2007 dollars), how much would you have to save each month right now? The answer may surprise you.

I just wrote up a post on Blueprint for Financial Prosperity about the differing performance returns of index funds, specifically a Vanguard and a Fidelity S&P index fund, that may be of interest to folks who invest in index funds as a component of their retirement investing strategy. The jist of it was that not all index funds are the same because their reaction times to index changes are different but that that knowledge is, unfortunately, useless because you can’t make any decisions based on it.

Given a choice though, I’d go with the fund with the lower fees every single time.

If you’re getting close to retirement and are a little slim on the retirement funds, do not try to compensate by ratcheting up your risk in an attempt to catch an up-swing as a means of catching up. First, don’t worry, you are hardly alone if you’re a little behind in your latter years. Second, the emphasis of your retirement plan should be on saving more. By creating a larger balance, you allow more reasonable rates of return, coupled with reasonable risk, to take over and get you where you need to be. Risk has a funny way of burning you when you least expect or can afford it, so avoid taking too much risk so close to retirement.

Now, if you’re a few years away from retirement, one alternative is to work a few more years so that your retirement savings can grow to where they need to be. A few more years of work means a few more contributions to your retirement savings, a few more years of the balance growing because of your investment choices, and a few more years for you to figure out what it is you want to do with your new free time.

Lastly, after you take advantage of the catch-up provisions in accounts like a Roth IRA, you might want to push the envelope on your investments and maybe put a little more in stocks than the general consensus. Don’t pick a hot new biotech to plow all your money into, that’s just straight stupid, you can’t afford to lose that money; but you can put a couple more percent into that index fund and maybe catch up that way. Don’t go crazy though!

I love Smart Money’s series, Ten Things Your [Insert Someone Here] Won’t Tell You, because it really opens your eyes to some of the shady practices of some operations you may otherwise think are being honest and above board. In the latest installment, Smart Money takes a look at 401K’s and the little things that go on that they just won’t tell you about.

1. “We’re making a mint on your 401(k) — even if you’re not.”
I think this is the most egregious of the ten things and it revolves around the fact that the provider is being paid on a percentage of the money its managing and not for their performance. A lot of their fixed costs are instead charged on a percentage basis, such as administrative costs, and while the assets may increase, the administrative (and other fixed costs) aren’t likely to increase on a one to one basis. Luckily these sort of things are coming under the scrutiny of state attorney generals, such as Eliot Spitzer of New York.

2. “You’re buying wholesale, but we’re charging you retail.”
If you buy a fund all by yourself, it’s understandable that you’ll be paying retail because you’re not talking about millions of dollars (or perhaps you are, in which case could you send some my way?). If you buy a fund through your 401k, it’s conceivable, based on how large your company is; that the administrator is moving around millions and you should get some sort of discount on the retail fees - and many times they do. The disconnect is when they pass the charges off to you, they don’t merely divide what they pay and pass it through, they charge retail fees for something they paid wholesale for. That should be illegal.

3. “No one in his right mind would buy these funds — given a choice.”
When you sign up to the 401k, you’ll likely be limited to which funds you’ll be allowed to buy. Unfortunately, sometimes this means that you get to pick from lackluster or under-performing funds because your plan administrator, someone in HR perhaps, doesn’t know what he or she is doing. Also, Smart Money warns that sometimes the funds can’t handle a huge influx of money (the reason why some funds close) because it’s harder to make the same rates when you have so much more to invest.

4. “Our ‘target-date funds’ may miss the target.”
This isn’t a 401k specific issue but one about the target-date funds themselves, some may be incorrectly allocated based on expert opinion, especially if your administrator (and not a large brokerage) sets it up. That’s not to say the big brokerages have perfect target retirement funds, it’s just that they have more minds on the problem which hopefully reduces the problem. There isn’t event agreement on allocation, I did a review of target retirement funds and found the allocations were all over the board.

5. “We offer tons of investment options. Too many, in fact…”
Just as #3 (too few funds) can be brutal, too many options muddy the waters. A survey showed that the average number of funds in a 401k was 19, but that 10-12 was the ideal number, anymore and the investor was “paralyzed.”

Things six through twelve will be forthcoming.

Source: Yahoo Finance

Need to know how much to save in order to retire a millionaire at the age of 65? Kiplingers has a whole slew of numbers to give you some confidence that you’re either on the right track or not that far away. The only assumptions they make are that you earn 8% annually on your money and that you don’t bet it all on black when you’re 64 and 11 months (okay, I may have made that last one up).

If you’re 25, to get to a cool million it only takes $286 a month. If you start at 35, you’ll need $671 a month to get to a million. At 45, you have a little tougher going but you’ll need $1,698 per month. If you’re 55, have nothing saved, you’ll need $5,466 saved per month in order to reach a million in ten years.

Some of the advice they give is pretty standard, such as contributing to a 401K if your employer offers a match, work a couple years longer past the traditional 65 retirement age, and contribute the max to your retirement accounts.

Source: Kiplingers

Taxes change, just like investments do, and in order to be prepared for whatever comes through the chambers of Congress, you have to diversify your tax profile. Simplistically, this just means that you need to have good mix of investments that are both tax-deferred and tax-free. For example, a Roth IRA is a tax-free investment vehicle. You put in dollars that are already taxed and your earnings and principal are tax-free when you withdraw them. A Traditional IRA is a tax-deferred investment vehicle. You put in dollars pre-tax and your earnings and principal grow tax free but they are taxed when you withdraw them. What happens if we do away with income tax and instead raise sales tax (a value added tax) across the board?

See, now your Roth IRA comes out of your fund tax free but is then “taxed” when you start buying things. You are essentially double taxed - once on the contribution side and then once when you spend it after withdrawing it. Now let’s say that the income tax is re-evaluated and it is doubled to help pay for nationalized health care… now you’re basically screwed on your tax deferred investments because you’re paying more taxes (and you win on your tax-free investments).

So, the next time you go to plot out your retirement portfolios, remember to not only diversify your investments but also remember to diversify your tax profile!

What is rebalancing? Rebalancing is when you re-assess your investment portfolio and adjust your holdings such that you return to the percentage allocations you planned for when you started the year. So, if you started the year 80% stocks, 20% bonds and, through the course of gains and losses, you find yourself at 75% stocks and 25% bonds at the end of the year - you should rebalance it by selling off some of your bonds and moving it into stocks. Rebalancing your portfolio is a crucial component of your retirement investing strategy for many reasons - not the least of which is the fact that you should stick to your plan and not let the latest hot run-up distract you.

1. Buy Low, Sell High

This is the cornerstone of rebalancing. If at the end of the year you have a higher percentage than you initially planned, then one can only surmise that it increased in value relative to the other holdings you have. Thus, it is now high and so you should sell it. The proceeds from that investment should go towards the allocation that has fallen during the course of the year - thus you are buying low. Buy low, sell high. You’ve been hearing it for years!

2. Stick To Your Plan
After you decided 80% stocks and 20% bonds should be your mix, you need to stick to your plan unless you have a good, unemotional reason not to continue on that path. Maybe you recognize the absence of international exposure, so you want 50% stocks, 20% bonds, and 30% international. Maybe you recognize an overallocation into stocks and want to ratchet it back to 60% stocks and 40% bonds. Unless you have a concrete reason for changing, you should rebalance and follow the plan of attack you set up for yourself twelve months ago.

3. It Makes Mathematical Sense
The math behind it is irrefutable and it does in part have to do with Reason 1: Buy Low, Sell High. For a the math explanation, please read Why Portfolio Rebalancing Works — It’s More Powerful than You Probably Think.

So go rebalance!

While most people agree that the best bang for your buck comes from index funds, sometimes you want to roll the dice a little and see if that hot shot mutual fund manager can get you a little better return than the market. Even though index funds are the best value, putting all your funds into one is just as bad as putting all your funds into one stock - you want some diversification on both a stock-bond level as well as a geographic level (and other levels).

Anyway, as is the case every year, Money Magazine put together a list of 70 actively managed mutual funds that they feel provide the best value for the investor on a variety of factors. They break the group up based on market capitalization for stocks, as well as groupings for bonds, international, and a specialty category (for things like real estate funds).

Don’t blindly invest in anything and definitely don’t invest in something just because you saw it in a list - just use this information as another factor in your decision on the funds you want to invest in.

US News and World Report had a little piece where they discussed some good New Year’s resolutions related to retirement and I thought that I’d put each of them through their paces. The ninth retirement resolution was to set a retirement savings goal.

Only 42 percent of workers have actually calculated how much they need to save for a comfortable retirement, according to EBRI. And 41 percent of those who did the calculation created their own estimate or guessed. It’s a good idea to sit down with a financial adviser and calculate exactly how much you will need to cover your expected retirement expenses or use an online calculator or retirement worksheet.

It’s always important to have a plan before you do anything and your retirement is no different. If you don’t know where you need to be and how much you’ll need to retire, it’s very difficult to be comfortable with how much you’re saving. Are you saving too little or even too much? Life is about balancing the enjoyment of your labor both now and into the future so you don’t want to put too much away into your nest egg, it’s almost as bad as not putting enough.

Now, it’s staggering that only 42% sat down and calculated how much they’ll need and that of those, 41% only guessed. Now, if you’re young and just entering the working world, it’s perfectly alright for you not to be focused on retirement outside of the basics. However, if you’re less than twenty years from retirement, it’s crucial that you sit down, do the math, and give yourself some confidence that your retirement plan is on track.

Source: US News and World Report