The world of retirement accounts and investing is filled with technical terms and phrases — it can be confusing, even if you’re on top of your finances.
If you ever find yourself wondering “What does [insert some confusing finance word or phrase] actually mean?” don’t worry — you’re not alone!
We get questions like this all the time, so we put together a list of key terms you may come across as you set up your IRA. So, keep reading to get the important details on a few of the most important financial terms you hear about, but may not really understand – yet!
Q: What is asset allocation and what does it actually mean?
A: Asset allocation refers to how your funds are split across different investment types, mainly stocks, bonds, and cash. Most people will shift their asset allocation over time in line with their risk tolerance and retirement timeline. For example, if you are young and far from retirement, you may choose an asset allocation of 90% stocks and 10% bonds to optimize for growth. In later years, you may shift to 80% stocks, 15% bonds, and 5% cash. When you are very close to retirement, you could shift to mostly bonds and cash. At the end of the day, there is no single right allocation strategy – the details will depend on your personal circumstances and risk tolerance.
Q: What’s a mutual fund?
A: A mutual fund is a professionally managed portfolio of investments where the money comes from a pool of investors (like you!). Mutual funds focus on different investment types; some focus on growth stocks, others on bonds, and some have a mix. Mutual funds are popular because they can allow you to diversify your investments. Like any investment, mutual funds are not 100% risk-free, but they tend to be lower risk compared to individual stocks. Mutual funds tend to have higher fees than some other funds because they are actively managed.
Q: What’s an ETF?
A: ETFs – or Exchange-traded funds – are collections of stocks that can be traded just like ordinary stocks on exchanges. ETFs try to mirror the performance of a well-known market sector or indicator, like the S&P 500 (check out Fidelity’s SPY or Vanguard’s VOO). Like mutual funds, ETFs can be an easy way to diversify your portfolio because they allow you to own a large number of stocks with only one transaction. They also tend to have lower expense ratios than mutual funds. This is because ETFs are passively managed as opposed to actively managed funds that require a lot more attention from investment professionals.
Q: What’s an expense ratio?
A: Put simply, an expense ratio tells you how much you’ll pay in fees to invest in a particular asset as a percentage of your invested assets. These most commonly apply to mutual funds and ETFs. These fees are used to pay for the expenses associated with running the fund. For example, if a mutual fund has an expense ratio of 1% and you invest $10,000, you will pay $100 in fees for the year. As a rule of thumb, mutual funds have higher expense ratios than ETFs because they are actively managed. Mutual fund expense ratios are typically between 0.5% and 1%, though some are more expensive. ETFs, on the other hand, hover around 0.2% (but can be lower).
Q: What’s a Target Date Fund? Is that just a mutual fund?
A: Target Date Funds (TDF) are investment vehicles – usually mutual funds – that change risk exposure over time depending on your age. They might be called something like “Target Retirement 2050.” When you’re younger, you are likely aiming for higher growth and are willing to accept higher risk. When you’re older, you may be more interested in cash preservation than growth, so you take on less risk (and less upside). The “2050” indicates this fund is for people who are aiming to retire around the year 2050. TDFs are a useful option for those who want simplicity – just check on the expense ratio to make sure you aren’t paying high fees.
Q: What does rebalancing mean in terms of my portfolio?
A: Over time, your asset allocation will naturally shift depending on your returns. Rebalancing is when you adjust your portfolio to bring it back in line with your desired allocation. For example: let’s say your target allocation is 70% stocks, 20% bonds, and 10% cash (70/20/10). Over time, the returns on your stocks could cause your portfolio allocation to shift to 80% stocks, 15% bonds, and 5% cash (80/15/5). In this, rebalancing would mean selling some of your stocks to reinvest in bonds and increase your cash stockpile, bringing your portfolio back to a 70/20/10 allocation.
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