The first thing you should do when starting a new job is to open a 401K account if you can. (If not, there are probably other, similar options such as a 403b account.) With the 401k, because this is our retirement savings, we can’t afford to take the kind of risks that we can take with our regular investment account. Also, most 401k accounts are limited in the investment choices, and some funds restrict trading, so they really aren’t suited for stock picking and rapid growth anyway.
With a 401k, the goal is to grow funds while minimizing risk as much as possible while still earning enough to outpace inflation. Because a savings account will always pay slightly less than the rate of inflation (yes, when you put your money in the bank, it is always slowly decaying away), the only options for a 401k account are stocks and bonds (and real estate if available as one of the options). While substantial diversification is not desirable for our regular investment account if we want to beat the market, because we really aren’t able to pick stock in a 401k account–being limited normally to mutual funds–diversification is desirable so that we can at least get market returns. While it is tempting to try to time the market, shifting from small to large stocks when we think large stocks will outperform small, or shifting out of stocks and into bonds when we feel that the market is near a peak, experience has shown that the rapid rises in stocks tend to occur over very short periods of time. If we try to time the market and are wrong, we’ll end up doing far worse than the market.
The good news is that this makes 401k investing very simple, requiring very little time. A good 401k plan will have a selection of funds that will include a money market, large growth stocks, small growth stocks, bonds, value stocks, and international stocks. Some funds may also include options such as emerging markets, REIT’s, commodities, junk bonds, and convertibles. Here’s the strategy when you’re 10 years or more away from retirement:
1. Invest equal amounts in the lowest cost funds in each of the main categories: large growth stocks, large value stocks, small growth stocks, small value stocks, and international stocks (20% in each). If you don’t mind some volatility, you can also put a lessor percentage in the other, more risky funds (REIT, emerging markets, etc…), but these positions should be smaller, for example, 5% in each of these with 15% in the main categories).
2. Each year (pick a date such as your birthday), rebalance the account so that the percentages are the same as you started with. This will mean that if the value funds do better than the growth funds during the year, for example, you will be selling some of the value funds and buying some of the growth funds – selling high and buying low. That’s it.
When you start to get within about 10 years of retirement, start shifting some of the funds over to bonds and income producing stocks, which are less volatile but also tend to produce lower returns, and then into cash (the money market)as you get very close to retirement for the funds that you will need within the next five years. At retirement you will therefore have about 40% of the funds in bonds and income producing stocks, 5% in cash, and 55% in growth and value stocks. As you get older you’ll continue to shift funds into cash as needed to cover five year’s worth of expenses and more funds into bonds and high yielding stocks since you can no longer stand the kind of market fluctuations that you could while you still had another source of income and didn’t need the funds right away.
Probably the most important thing to avoid is taking money out of your 401k account or borrowing from it before you are ready to retire. 401k accounts sometimes get bad names when compared to pensions, but the main reason is that people withdraw all of the money from their 401k account each time they change jobs or just to pay off bills. This causes them to lose the effects of compounding over thirty or forty years – you’ll make most of your money in the last few years. You’re not able to withdraw funds from a pension early, so even though pensions return maybe 5-6%, compared to 10-15% for a 401k invested in stocks, pensions end up looking like the better choice. Avoid the temptation to take the money out (you’ll pay taxes of 35-50% anyway) and you’ll end up with a lot more at retirement than you would have if you had a standard pension plan.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. 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. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.