On Monday we talked about financial advisors and how their interests are not always aligned with your interests.  Your interest is obviously to make the most money possible.  We would all rather retire to a life of leisure and luxury than to a life of social security payments and tough choices (like whether to eat or buy medicine). 

Let's start with the one thing I never recommend for retirement accounts; Stocks.  Some people will call me crazy, but for the average investor there is not a place for individual stocks in a retirement portfolio.  Individual stocks are simply to volatile for any risk level.  If you have your retirement plan setup and on auto-pilot, your kids education planned for and also on auto-pilot, then by all means go ahead.  Open up a brokerage account try your hand at buying and selling individual stocks.

For everyone else, you need to be looking at mutual funds and index funds.  Dave Ramsey regularly suggests that his listeners invest in good growth stock mutual funds.  It's decent advice and if you are going to invest in mutual funds then growth stocks are where its at.  However, I think a better place to be is with index funds.

What the heck is an index fund?

From Wikipedia:

An index fund or index tracker is a collective investment scheme (usually a mutual fund or exchange-traded fund) that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.

Still confused?  Basically, these look, taste and smell like mutual funds (actually they are mutual funds, but don't tell anyone).  The big difference is that they don't have a Suit (I.e. big-wig, I am smarter than you, Harvard educated fund manager) trying to time the market.  Instead these types of funds are setup so that they mimic the market.  For example, you might choose an Exchange Traded Fund (ETF) that follows the S&P 500.  When the S&P goes up so does your fund and likewise when the S&P goes down, so does your fund.

Given the current economic turmoil you might question having your investments copy any of the major indexes.  I can't say that I blame you considering that in 2008 the S&P 500 took a 37% nose dive.  However, when you look at the big picture things start to look a little brighter.  Take a look at this graph showing the historical performance of the index:

The average (Arithmetic Mean) return, over the 50+ years the index has been in existence, is 13.04%.

These funds have several key advantages.

1. Very low or no fees -- Unlike managed funds there aren't teams of economist and an overpaid fund manager to pay.  The stock selection is largely rules based or directly mirrors the weighted allocation of the index.  This leads to a drastic reduction in costs.  For example, the typical index fund spends .03% in operating expenses and .02% in transaction costs.  Compare that to the typical 2% of a mutual fund.
2. Dead Simple -- There is probably not an easier investment to make.  Not a lot of research to do here, because you are effectively trying to match the market and not beat it.
3. Proven Track Record -- The average return for any 15 year period will more than likely blow the return of most mutual funds you can find out of the water.
4. You won't under perform the market -- As the vast majority of managed equity mutual funds have done in the past.  A great example of this is the Vanguard S&P 500 Fund which has "out performed 90% of all domestic equity mutual funds over the past three and five years."

Index funds clearly have some advantages but that doesn't mean that you can simply "Set it and forget it!"  This is still investing and it still incurs some amount of risk.  Remember the first step is to educate yourself and then make informed decisions. 

Ironically, the largest disadvantage is also the largest single advantage and that is that the fund directly mimics the market.  Because the fund mirrors the index, if the index tanks so does your portfolio.  For example, during the dot com bubble in 2000 people of who had invested in NASDAQ index funds took huge losses, and I already mentioned the S&P took a huge nose dive in 2008.  However, both of these were short term losses.  It would be devastating if your time horizon was short, so if you will be retiring in the near term then you need to make sure you remove as much volatility as possible from your portfolio and move those investments into less risky vehicles.

For a nice introduction into index funds see The Motley Fool.