Starting a new job comes with a lot of challenges. One of the biggest for many is how to invest contributions placed in a 401K account. Basic financial concepts like credit and budgeting are rarely covered in schools, let alone investing, so few new workers know how to allocate their funds. Parents are also often of little help, having never invested themselves since the 401K account is still a relatively new concept and they may have dealt only with a pension fund.
A 401k account is actually a lot better than a pension. Invested correctly (and perhaps more importantly, fully funded) one can do a lot better with a 401k than one could have done with a pension. Returns on pensions were typically limited to perhaps 5-8%, while 401k returns can average 12-15%. In addition, one will have access to the entire 401k account at retirement, where one would receive payments from a company or an annuity with a pension. One can also leave the remaining balance in a 401k to heirs, where a pension normally stops when a worker, and perhaps her spouse, dies. Unfortunately, perhaps, the worker is normally left to manage his 401k account.
Luckily investing in a 401K is really not that difficult. It is just a matter of choosing a percentage of your paycheck to invest, finding what funds are available and categorizing them, setting up how new money will be invested in those funds, and then rebalancing your funds periodically. Let’s go through each of those steps.
1. Choosing an amount to invest
You will want to be investing between 10 and 15% of your paycheck for retirement starting from the day you start work (before you start committing your paycheck to other things) . The more you invest, and especially the more you invest while you are young, the more you will have at retirement. And we’re not just talking a little more – we’re talking the difference between $100,000 and $10 M. This is because every dollar you invest when you are 20 in equities will be worth about $120 when you are 65. To ensure you have plenty of money to make it through retirement and live comfortably, you should be putting away at least 10%. Putting away 15% will just make your future that much more certain.
This 10-15% goal is also regardless of employer contributions. The reason to ignore employer contributions is that unless some money is directed towards investments or savings, people tend to increase their spending until it equals their income. If you choose to only invest 5% because your employer matches 5%, it is unlikely that you will be able to make up the difference and begin contributing 10% of your paycheck should your employer stop contributing, To do so would require you to give up something to find the additional 5%. Rather than make a sacrifice, you might choose to go without the additional contributions to your retirement accounts. This could be devastating to your retirement.
If you start out putting away 10-15% from the start, you will be used to living on less so you’ll be in good shape even without the employer match. In that case the employer match is just a bonus that further ensures you’ll be set for retirement. If your account builds up by the time you are in your forties to the point where you’ll have a lot more than you need, you can then reduce the amount you are contributing and instead put more into a taxable investment account so that you start generating more income for near-term expenses and use some of the money for luxuries or other expenses (like the kids’ college bills).
This does not mean the whole 10-15% should go into your 401k. You will have more investment options (and possibly lower fees) if you also setup and invest in a private IRA. Contributions should therefore be made as follows:
1. Put enough in your 401k account to receive the full employer match.
2. Max out your IRA and your spouse’s IRA account contributions. Check with your tax advisor to determine which contributions will be tax-deductible if using a traditional IRA.
3. Contribute any remaining amount to reach your goal (10-15%) to your 401k.
2. Determining available mutual funds and categorize.
The first step when selecting investments is to look at the description of the available mutual funds in your 401k plan to determine their investment style. Some of this information should be available from your HR department or the plan administrator (the best source of information for a fund is called a prospectus, which a mutual fund company is required to provide to all investors). You can also go to Morningstar, which provides information on virtually all funds. For example, here is a Morningstar analysis for the Vanguard Explorer Fund.
What you are looking to determine for each fund, more than anything else, are 1) the types of assets the fund invests in and 2) the fees charged by the fund. The types of assets will be asset type (stocks, bonds, real estate, etc…). For stocks, these will be further broken down by asset size (Large, Midcap, or Smallcap) and funds will be classified as growth or value. Note that this is shown in the style map in the prospectus and in the Morningstar report. For example, in the case of the Vanguard Explorer fund, note that the value map (about midway down the right side) shows that it is a High Growth fund that invests in small caps. Go through each of your available funds and write down the fund asset type and the fees. For stocks, write down whether they are large, mid, or small cap and whether they are growth, income, or a blend.
3. Choosing fund allocations.
Option 1: If you don’t want to deal with any of this and have the choice of a date-based retirement fund in your IRA (like a “Retiree 2040 fund”, where 2040 refers to the year, 2040), choose the one closest to your retirement age and you are done. (Choose the one before your retirement age if you are more conservative or the one after your retirement date if you are more aggressive.) These are funds specifically designed to provide about the right mix of stocks and fixed income for people who are to retire around a certain date. They automatically adjust the allocations each year, so it is a “set it and done” type investment.
Option 2: If you want to spend a little more time and perhaps do a bit better, the first step in allocating funds is to determine the percentage of stocks and fixed income investments you would like to hold. You will get the best return over long periods of time (ten years or more) if you invest entirely in stocks, but adding a little fixed income will reduce the volatility – the amount the account goes up and down in value – without sacrificing too much return. The general rule-of-thumb is to invest your age in fixed income. For example, a 30 year-old would invest 30% in fixed income and 70% in stocks. This is fairly conservative, so investing your age minus ten would be most appropriate for most people. So, here are the options:
A. If you don’t mind a lot of volatility, are less than 45 years old, and want to get the best possible return, put 100% in equities.
B. If you want a good return but want to reduce the volatility a bit so that you don’t see your account value cut in half during major downturns, or if you are 45 or older and therefore don’t have that long to recover from a significant downturn, invest your age minus 10% in fixed income and the rest in stocks.
Once you’ve determined the percentage of stocks and fixed income investments, choose specific funds. Here are three options that will all produce good returns. Do the best you can, given the funds available to you, to develop a portfolio that roughly matches one of these options. Note that as long as you have the percentage of stocks and fixed income about right, you’ll do just fine in any case. The question is just if you want to add a little complexity for a little more return (possibly):
Portfolio A: Keep it simple.
Stocks: Choose a Total Stock Market Fund or a Large Cap Growth Fund and a Small Cap Blend or Growth Fund.
Fixed Income: Choose a Total Bond Market Fund
Portfolio B: A little more complex.
Stocks: Chose a Large Cap Growth Fund, an International Stock Fund, and a Small Cap Blend or Growth Fund.
Fixed Income: Choose a Total Bond Market Fund and a REIT Fund or a Dividend Fund
Portfolio C: All the bells and whistles.
Stocks: Chose a Large Cap Growth Fund, an International Stock Fund, a Large Cap Value Fund, and a Small Cap Blend or Growth Fund.
Fixed Income: Choose a Total Bond Market Fund an REIT Fund, and a Dividend Fund
When choosing funds, pay attention to fees rather than past performance. It is unlikely that you will have too many choices of funds that do the same thing within a 401k plan. These plans tend to have limited choices. If you do have a choice, however, the single best way to choose between funds is to find those with the lowest fees and expenses. These tend to be index funds rather than actively managed funds. This is because over long periods of time the performance of a fund will follow the performance of the market and have about the same return. The fund that charges the least, therefore, will provide the best return.
In your 401k account, designate to invest approximately equal amounts in each fund in a category. For example, if you are investing 20% in bonds and 80% in stocks and using Portfolio B, you might specify:
Stocks:
Large Cap Growth Fund 25%,
International Stock Fund 20%,
Small Cap Blend 25%.
Fixed Income:
Total Bond Market Fund 10%
Dividend Fund 10%
4. Rebalance
Once you have specified your allocations, sit back and relax for a year (but don’t forget to make your IRA contributions). Your account balance will grow through the first year, mainly from your contributions. At the end of the first year, you’ll need to rebalance the portfolio since the balances will differ from your allocations because of changes in the market value of your funds. In rebalancing, you move funds around to make the percentages invested in each fund match your specified allocations.
For example, let’s say you chose the simple portfolio and have allocated as follows:
Total Stock Market Fund: 80%
Total Bond Market Fund: 20%
Let’s now say that stocks declined a bit during the year while bonds did well, such that you now have 25% in bonds and 75% in stocks. You could move money from the bond fund to the stock fund to regain the 80% stocks, 20% bonds percentage. In doing so, you’re selling and taking a profit in the bond fund that did well and buying more of stock fund that declined in price, thereby purchasing shares more cheaply.
Most funds make it easy to rebalance by providing a tool to automatically rebalance an account to match your contribution specifications. Note that it makes no sense to do this, however, more often than about once a year. To do so can result in fees being charged by the funds due to the extra expenses they occur.
Another alternative to selling shares of one fund and buying another is to shift your allocations. In other words, to change the amounts you’re contributing to each fund. For example, if you are overweighted in stocks, you might direct new purchases to the bond fund for a while. Just be sure you don’t forget to change the allocations back once things get into balance.
You would also periodically change your allocations based on your age. For example, every five years or so you might adjust the percentage of stocks downward and that of fixed income upward, adding more fixed income assets as you get older and can’t risk a major market setback.
With just a little time to set things up, 401k investing is a breeze. Perhaps the most important thing is to take advantage of the account and put money away. In forty years when you’re enjoying a comfortable retirement, you’ll be glad you did.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
