The picnic basket analogy of investing

Years ago, I had a chat with someone that told me a story that I’ve unfortunately heard many times over my career, but nonetheless, never ceases to surprise me. Let’s call her “Melissa” for the sake of this article. Melissa was near retirement, single, and had worked diligently her whole career in the manufacturing industry. She paid little attention to an old 401(k) that was rolled over into an IRA nearly ten years ago. But finally, after hearing her co-workers gush about their investment performance, Melissa took a closer look. Her investments were barely earning any interest at all and had not earned more than 1% or 2% for almost ten years. When she investigated her account, she found that by default the money in her IRA was just swept into a general money market fund. This is very common, but she was shocked to find she had not owned any actual stock funds for nearly ten years and had never really invested her funds! She assumed that the IRA account was automatically investing for her, and this is a grave error that I see many people make when they are first starting out learning about their investments.

The fundamental mistake that Melissa made was misunderstanding the difference between “baskets” (401(k), 403(b), IRA, 529, brokerage accounts) and the things inside the basket (stocks, bonds, mutual funds, ETFs). For people that are financially savvy, this is an obvious distinction, but I’ve seen the mistake enough over the years to know confusion is commonplace. Baskets are types of accounts. They have different limits on how much a person can add to them, when they can add to them, and how they are taxed when they eventually start pulling items out of the basket. In other words, the baskets all have different shapes, sizes, and rules on what they can hold and when the items can be pulled out. In contrast, the items inside the basket are your actual investments, and they need to be purchased by a broker that allows both amateurs and professionals to access public markets. If you never put any items in your basket, you will be left holding cash. The most common basket item is stock shares of public companies, which represent a tiny sliver of ownership in that company. Bonds are another basket item, which is money that you loan to a company or government and then they pay you a monthly amount before eventually giving you back your principal after a specified amount of time. Bonds are heavily tied to interest rates, so they tend to be much lower risk, lower reward compared to stock. Other basket items include real estate investment trusts (REITS), commodities like gold, oil, copper, or grain, and even cryptocurrencies (though these are still not easily available in retirement plans).

Controlling the items in your investment baskets is important, and I have three general suggestions to properly implement a savings and investment plan:

1) Understand your baskets.

2) Diversify the assets in your baskets.

3) Place the assets in your baskets in the right order.

Understanding the nuances of the variety of investment baskets can be daunting. The acronyms alone are enough to drive most people crazy: 403(b), 401(k), 457, 529, HSA, FSA, IRA, ROTH, SEP, SIMPLE. If you really hate yourself, you can try and learn the differences between types of trusts: marital, bypass, living, AB, ABC, revocable, irrevocable, testamentary, charitable, credit shelter, and so on. Clearly, exploring these different baskets might require a professional financial planner. But there are some key points to remember. First, IRAs (Individual Retirement Accounts) and your employer-sponsored plans are usually tax deductible, depending on your household income. Interest and dividends inside the accounts accumulate tax-sheltered until you withdraw money from them, usually at the age of 59.5. This allows you to defer paying taxes on your income and earnings until later in your life. You might also have a ROTH IRA or 401(k), which is not tax deductible, but can be withdrawn tax-free in retirement. All the accounts above have contribution limits (how much you can add each year), different tax treatment, income limits (your income determines if you can contribute and how much), and different rules for withdrawals and penalties. You need to understand these baskets before you start using them, or consult with somebody that does.

You also want to diversify the items inside your baskets. Nobody wants to go on a picnic with only plain bread in the basket. You need to add some meat and cheese, vegetables, and dessert. Your picnic (and your retirement) will be more successful. This means you should diversify between what we call asset classes: U.S. stock, international stock, large companies (large cap), medium and small companies, emerging markets, government and corporate bonds, and even alternatives like real estate, gold, or cryptocurrencies. The key to diversification is that you have some assets that are not correlated with each other. Bonds might go down one month, while U.S. stock soars. Or perhaps foreign emerging markets have a great year, while the U.S. market suffers. Diversification decreases risk and lends your portfolio some stability against risks associated with specific governments, companies, or even political unrest. Secondly, your portfolio needs to be diversified by sector. Sectors include technology, communication services, consumer, energy, financial services, healthcare, and more. Your portfolio should be exposed to many different types of industries to protect your money against sector underperformance. In March 2020, tensions between Russia and Saudi Arabia in combination with the lack of travel from COVID-19 lockdowns devastated the oil industry and the stock of most energy companies. If you held mostly energy stocks in 2020, you had a real bad year. But the technology and healthcare sectors did great, and if you were appropriately diversified, you would have had no problem balancing out the disruption in the oil sector. In contrast, after the invasion of Ukraine by Russia in 2022 and the global increase in energy costs, oil companies thrived while technology and healthcare companies suffered.

Finally, you want to put your investments inside your baskets in the right order. The “right order” depends on your personal situation, but there are some basic guidelines that work for most people. You always want to take advantage of free money before any other consideration. That means if your employer includes a company match, always contribute at least that amount before considering any other baskets. Why would you ever not take free money? Obviously, if it is a question of feeding your family and contributing 5% to your 401(k), you would not take the free money, but if the option is there, you should take it. After hitting your employer match, you then want to switch gears and max your IRA. In 2023, people under 50 can contribute $6,500 and folks over can contribute $7,500. IRAs generally provide you with more options than employer plans for lower fees. If you still have more money left, you want to go back and max your 401(k) or equivalent. If you still have more available money after maxing your IRA and employer plan then you want to investigate other tax-sheltered plans like Health Savings Accounts (HSAs) or 529s (College Savings Plans), but it really depends on your goals, and financial situation. If those plans are not available to you, or not necessary, then your excess funds should go into taxable baskets like brokerage accounts or living trusts. I see many people investing in taxable accounts before their IRA and retirement plans are maxed. If you are saving for retirement, this is a poor decision. Why would you pay taxes for decades if you did not have to? The only reason to use a taxable account before a tax-sheltered plan would be if you need the money relatively soon, though there are still options for using plans like ROTH IRAs, which allow you some flexibility for removing your funds prior to age 59.5. Understanding your investment baskets and putting the investment items in the right order is a critical part of saving for retirement and growing your wealth for the future.