Getting the best return out of your retirement savings can be complicated. However, index funds have made it far easier for regular folks to invest better. Not only can index funds help you get the best returns and gain exposure to different market sectors, they can also help you manage your portfolio's risk and volatility, particularly as you transition from a growth focus and enter into retirement, where income and reduced volatility become more important.
We asked three Foolish investors for a little help identifying some index funds for your IRA, and they picked Vanguard 500 Index Fund Investor Shares (NASDAQMUTFUND:VFINX), Vanguard Total Bond Market ETF (NASDAQ:BND), and Vanguard Real Estate Index Fund Investor Shares (NASDAQMUTFUND:VGSIX).
Not only are these all low-cost funds that are easy for investors to buy, but they serve as great ways to accomplish particular goals and build a balanced portfolio.
Warren Buffett won a bet with this one
Maxx Chatsko (Vanguard 500 Index Fund Investor Shares): Warren Buffett is the world's most famous advocate of long-term investing and is well-versed in the powers of compound interest. But no matter how much successful his approach is, it seems there will always be people who'd rather chase flashy investments.
For instance, in 2007 Buffett bet Protege Partners $1 million that the S&P 500 would outperform hedge funds. To make his point, the Oracle of Omaha staked his reputation on Vanguard 500 Index Fund Admiral Shares, which owns shares of the 500 largest American companies. The goal of the fund is simple: to track the performance of the U.S. stock market.
So who won? Buffett -- and by a landslide. The Vanguard 500 Index Fund Admiral Shares beat the compounded annual return rate of hedge funds selected by Protege Partners by a whopping 5%. The bet was made in good fun, of course, with the bounty being donated to charity. But the lesson is clear: Sometimes simplicity is best.
While the Vanguard 500 Index Fund Admiral Shares requires a $10,000 minimum investment, the IRA-friendly counterpart -- Vanguard 500 Index Fund Investor Shares -- only requires a $3,000 investment to get started. It does the exact same thing: match the annual returns of the S&P 500. Put another way, a $10,000 investment made at the beginning of 2008 -- before the Great Recession, mind you -- is worth $25,014 today.
Protecting the downside
Jason Hall (Vanguard Total Bond Market ETF): If you're still decades away from retirement, the vast majority of your IRA should be invested in stocks. Bonds simply don't offer enough yield to make them worthy investments for long-term wealth-building. But as retirement gets closer, it's important to start moving the portion of your nest egg you'll sell within a few years into less volatile investments. The Vanguard Total Bond Market ETF is an excellent choice.
This fund is comprised of investment-grade bonds; a mix of 70% government and 30% corporate, across short-, intermediate-, and long-term issues reflecting the general mix of the U.S. investment-grade bond market. The point of this investment isn't to get the biggest return (and its roughly 3% yield surely won't). But it can help you avoid big short-term losses.
In a market sell-off, stocks can lose significant value with very short notice. During the financial crisis, stocks lost more than half their value in less than two years. Even worse for anyone needing to sell, it took stocks more than four years to fully recover.
The Vanguard Total Bond Market fund not only held its value during the worst market crash in 80 years, but delivered over 30% in total returns. This downside protection for short-term investments makes this fund an ideal holding for retirees.
The benefits of real estate ownership without the headaches of being a landlord
Chuck Saletta (Vanguard Real Estate Index): Many people like the idea of owning real estate as part of their portfolios, but that can be tough for small investors to break into. To directly buy an investment property, you generally need a 25% down payment to get a decent interest rate.
In addition, to get some semblance of diversification in your real estate portfolio, you'd need several properties. The out-of-pocket costs can easily swamp the average person's available nest egg. As if that weren't enough, if you'd like to own real estate in your retirement account, it can be extra challenging due to the restrictions, costs, and potential taxes you would face.
That combination makes Vanguard's Real Estate Index Fund a wonderful index fund for you to consider instead of directly owning real estate in your IRA. As an index fund, it's diversified within its industry -- in this case, real estate. As a mutual fund instead of direct ownership in property, you can own it inside your IRA without the headaches. And with a reasonable $3,000 minimum initial investment level, access to it is within reach of many ordinary investors.
The Vanguard Real Estate Index Fund currently yields around 4.6%. Since it invests in real estate investment trusts, the income portion of that higher-than-average yield is generally taxed as ordinary income at your marginal tax rate, not qualified dividends. That's another reason to consider owning it in your IRA, as the taxes on those distributions can be deferred at least as long as the money stays in your IRA.