An Ignoble Experiment: Why Mutual Funds Are Still the Best Pick for Retirement Investing

Why Mutual Funds Are Still the Best Pick for Retirement Investing

For 20 years, in all types of economic climates, Dave's retirement investing advice has remained the same: Invest in growth stock mutual funds with a history of strong performance.

But the investing world is full of options for your retirement money. And some of those options have attractive features like principal guarantees that protect the money you invest. Others guarantee a specific rate of growth.

That sounds great until you dig a little deeper. Let's take a look at some of your retirement investing options and see why, in spite of some of their benefits, Dave believes mutual funds are still one of the best ways you can invest for retirement.

Annuities Charge a Price for Security

Pros: Fixed annuities are sold by insurance companies as a tax-advantaged retirement savings option. They guarantee your principal and guarantee a fixed rate of return for a certain time period. Fixed annuities are designed to deliver a guaranteed income either for the owner's lifetime or for a specific number of years.

Cons: All that security comes at a price. The best annuity rates barely keep up with inflation. That would be bad enough since it means you end up losing some of the purchasing power of your money each year. But the annuities' high fees eat away at your remaining investment growth. So even though you won't lose money with an annuity, you won't achieve the growth you need to build up enough savings to support you through 20–30 years of retirement.

Annuities also charge steep penalties if you need to access your money during what's called a surrender period—anywhere from two to 10 years. The penalties start at 10% of the amount withdrawn—that's on top of any tax penalties you'd be hit with if you tried to withdraw the money before age 59 1/2.

Mutual Fund Advantage: Annuities do allow your money to grow tax-deferred, meaning you won't owe income taxes on the money in your annuity until you withdraw it. But you can get the same tax benefit by investing in mutual funds through your 401(k) or in a traditional IRA.

Plus, mutual funds have the growth potential you need to build a nest egg large enough for a comfortable retirement. To achieve that growth, work with an experienced investing advisor to carefully select your funds, devise a long-term investing strategy, and maintain that strategy over the long-term whether the stock market is swinging up or down.

ETFs, the Mutual Funds' Close Cousin

Pros: Exchange Traded Funds (ETFs) are similar to mutual funds with a few key differences. Originally, ETFs tracked, or invested in, the same companies as those included in an index like the Dow Jones Industrial Average or the S&P 500. ETFs are super-cheap because unlike mutual funds, there's no team of managers researching and selecting companies for the fund to invest in.

Cons: Another major difference is that ETFs are designed to be traded on the stock market exchanges during the trading day, allowing ETF investors to buy or sell in response to daily stock market swings. Mutual fund transactions are completed after the markets close.

For the long-term investor, ETFs simply aren't a good fit. The ability to trade ETFs like stocks makes it too easy for investors to try to time the market for short-term gains—the complete opposite of a sound, long-term strategy.

Mutual Fund Advantage: "Investing in" an index isn't a bad idea for your retirement. The S&P has averaged nearly 12% growth over the long-term, after all. But you don't need an ETF to track an index. Index mutual funds accomplish the same goal without the temptation to day-trade. Your investing advisor can show you where index funds can play a part in your portfolio.

Stocks and Bonds: Too Much Risk for Too Little Reward

Pros: Stocks and bonds are the original investing heavy hitters. When you buy stocks, you're buying a tiny piece of the company that issued the stock. So when you buy a Coca-Cola stock, for example, you become part-owner of the Coca-Cola company. As the value of the company grows, so does the value of your stock.

When you buy a bond, you're lending money to the company, city, state or country that issued the bond. You make money when the borrower pays you back with interest when the bond matures—usually a period of 3–15 years. Or you can sell your bond to investors who think you've gotten a better deal than they could get with today's current bonds.

Cons: Both of these options carry a ton of risk. Investing in single stocks is like putting all your retirement eggs in one basket. If something happens to the company whose stock you own, the value could drop and never recover.

The value of bonds rises and falls in the opposite direction of interest rates. So if interest rates rise after you purchase a bond, its value drops. Interest rates are incredibly low right now, and there's only one way for them to go. When rates start to rise, the value of your bonds could drop like a rock.

Mutual Fund Advantage: Dave agrees stock market investing is your best chance to build up enough savings to support you through retirement—but not with single stocks. Normal stock market cycles cause stock values to surge and plummet, and that's too much for most investors to handle emotionally.

Mutual funds allow you to own stock in hundreds of companies at once and spread out your risk. If something happens to one company in your mutual fund, your entire retirement strategy won't go down the drain. It's the best way to use the power of the stock market to build up your retirement savings.