Even though retirement is still decades away, millennials are increasingly jumping on the savings bandwagon.
According to Fidelity Investments’ 2016 Millennial Money Study, 60 percent of young adults are saving for retirement and 62 percent have an investment account. When it comes to what they’re investing in, mutual funds are a top choice.
The Investment Company Institute estimates that nearly one-third of millennials owned mutual funds in 2015. Forty-five percent of young investors are holding these funds through an employer-sponsored retirement plan.
Mutual funds can be a less intimidating proposition for 20- and 30-somethings who may be leery of purchasing individual stocks. If you’re using mutual funds to advance your retirement goals, either through an employer’s retirement plan, an individual retirement account or a brokerage account, here’s what you should be keeping in mind.
[See: 12 Steps Toward a Stronger 401(k).]
Think about your time frame. When you’re investing in your 20s or 30s, time is literally on your side and that’s something you should be using to your advantage, says Jeremy Torgerson, CEO of nVest Advisors in Brownsville, Texas.
“Time in the market is far more important than timing the market,” Torgerson says, and millennials should be taking a diversified but aggressive approach to their portfolio.
For Torgerson, being a disciplined saver and keeping emotions in check when dealing with swings in the market are more impactful than trying to time the market or choose the very best fund.
He says millennials tend to think of themselves as sellers during a stock downturn when they should be thinking of themselves as buyers. When the market is down, that’s a good time to buy, since everything is on sale. The No. 1 mistake younger investors make is going too conservative with their strategy without considering how that can play out over several decades.
“Stock market volatility can be scary but unless you need to use money from your investments this month, it doesn’t matter in the slightest,” Torgerson says.
Derek Mazzarella, an investment specialist with The Bulfinch Group in Needham, Massachusetts, says millennials should direct more of their focus toward mutual funds that invest in equities, versus mutual funds with a heavy concentration in bonds.
“The long-term investment horizon will give the younger investor the ability to overcome a down market,” Mazzarella says.
Make tax efficiency a priority. Where you put your investment dollars can carry as much weight as fund choice, especially if you’re concerned about increasing your tax liability. Younger investors need to be aware of the differences when investing in mutual funds through a qualified retirement plan and a taxable investment account.
“The tax efficiency of certain investment vehicles is irrelevant within employer-sponsored retirement plans,” says Matt Gulbransen, owner of Callahan Financial Planning Corporation in Minneapolis.
With a 401(k), for instance, your growth is tax-deferred and contributions are deducted from your taxable income for the year. Regardless of what you’re investing in, there’s no taxation until you begin making qualified distributions in retirement. The same is true of a traditional individual retirement account.
When you invest in mutual funds via a Roth IRA, you’re using after-tax dollars so there’s no added tax consequence once you begin making withdrawals from your account. If you’re investing outside of an employer’s plan or IRA, on the other hand, the tax implications could be very different, Gulbransen says.
[Read: How Will Robo Advisors Impact the Future of Investing?]
With a taxable account, you must factor in the impact of capital gains. Capital gains tax is triggered when you sell a mutual fund or another investment at a profit. The short-term capital gains rate applies to investments you hold for less than one year. The more favorable long-term capital gains rate kicks in for investments you own for longer than a year.
If you’re investing in mutual funds through a taxable account, you’d want to look at funds that trigger the least number of taxable events. Index funds or exchange-traded funds, for instance, tend to have a lower turnover rate compared to an actively managed fund. At the end of the day, you’d be better off investing in these types of funds through a brokerage account and leaving actively managed funds in your 401(k).
Evaluate the fees carefully. The old adage of “you get what you pay for” isn’t always necessarily true when it comes to mutual funds. A cheaper fund isn’t a sign of poor performance and fund with a higher fee structure isn’t guaranteed to be a winner.
That’s something younger investors need to keep in perspective, says Chris Georgandellis, a chartered financial analyst with Tree Town Investments in Ann Arbor, Michigan. “In an ideal world, there would be positive correlation between fees and performance,” Georgandellis says.
The problem arises when you’re paying high fees on a yearly basis but the fund doesn’t deliver on the same schedule. “It’s extremely difficult to beat the S&P 500 consistently and it’s even more difficult to pick out in advance one fund that will do so,” Georgandellis says.
Given a choice between low fees, which are typically associated with more passive funds that try to match the performance of a broader market index, and higher-fee active funds, investors are better off with the low-cost option, he says.
Don’t be dazzled by short-term performance. Aside from looking at the relationship between fees and performance, younger investors should also be turning an eye toward the long-term outlook of the mutual funds they’re investing in.
Mike Hohf, a certified financial planner and financial advisor at Advance Capital Management in Southfield, Michigan, says attempting to chase performance is a serious mistake.
“Markets work in cycles,” Hohf says. “It’s unlikely that the investment that did the best last year will repeat that performance this year.”
Gulbransen says one of the biggest dangers for millennial investors is allowing emotion to cloud their decision-making process. Like Hohf, he points to recency bias as a potential trap that young adults tend to fall into, while acknowledging the role of media influence in shaping investment decisions.
[See: 13 Ways to Take the Emotions Out of Investing.]
“There are endless opinions and advice about what’s happening in the markets and the world,” he says. “As investors we need to have a long-term commitment and avoid the short-term noise.”
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4 Things Millennials Should Know About Mutual Funds and Retirement originally appeared on usnews.com
