In listening to advertisements from financial advisers, you would think that if you don’t select just the right funds for your 401K you will retire a pauper. While there are certainly some big mistakes that you can make with a 401K or mutual fund investing in general, most of them really don’t have that much to do with fund selection.
Yes, it is true that there are ways to juice your returns a little bit, at least most of the time. And it is true that if you increase your returns a little, you’ll end up with a lot more (in dollar terms) than you will if you don’t. But still, if you have two middle-class individuals who both invest 10-15% of their paychecks regularly in a set of mutual funds, they’ll still end up multi-millionaires at retirement. The person with the better strategy may end up with $8M while the one who doesn’t might end up with $6M. Yes, $2M is a lot of money, but compare this with the person who doesn’t think about retirement until they are fifty or even sixty years old (in other words, 95% of people). These folks will be lucky to scrape together $250,000 before retirement.
The thing you should worry about more is some sort of wealth tax or confiscation of assets in the future in the name of “fairness” because of wealth inequity such as this. Nevermind that you saved 15% of your paycheck to allow you to end up with several millions while many other people spent their entire check (and then some), and that’s why they ended up with nothing for retirement. It is easy to stir up a nation full of grasshoppers against a few ants.
The investing part though is relatively easy. 1) Select a large cap fund, a small cap fund, an international fund, and a high yield (bond) fund. 2) Put money into the bond fund equal to your age minus 10. If you are less than 50, you might want to not put any in the bond fund at all if you can handle the ups and downs of the market (bonds help to smooth out the ride but reduce your long-term returns). 3) Divide the amount that remains about equally into the three stock funds. You’re done! Then, just rebalance the money about one a year to do a little better. If this is too much, just use a total market stock fund and an international fund, divided about 70-80% domestic and 20-30% international with the rest in the bond fund. Still too hard? Just use a target date fund corresponding to your birthdate, or your birthdate plus 10 years if you want a little better return and don’t mind the volatility.
So what are the big mistakes to avoid when investing for retirement or building a portfolio of mutual funds to become financially independent? Note that fund selection isn’t one of them, since investing regularly in most common stock funds is profoundly better than not investing at all.
1) Spending principle. The biggest mistake you can make is to withdraw the money from the mutual funds and spend it. You will never be able to build up funds and take advantage of the power of compounding if you keep eating your seed corn. Withdrawing and spending the money from a 401k (or even doing something like using your 401k like using your 401K funds to start pay off your house or start a business) is even worse since there you’ll pay out about half of the money in fees and taxes. To be successful at investing you need to have the attitude that once money is invested it must stay invested. Only the interest and gains can be spent, and most of that should be plowed back into the investments while the value of assets you have is small so that your portfolio can grow.
2) Holding too much cash. The second biggest mistake is to hold too much in cash assets such as bank CDs and money market funds. These assets will lose 2% or more each year to inflation, so if you hold onto cash assets for long periods of time your spending power will deplete. Money that is not needed for five to ten years needs to put in assets that increase at least as rapidly as inflation, which means stocks, real estate, and bonds.
3) Making large moves to try to time the market. It is often tempting to sell out and move into cash when the market has had a big run-up and everyone is saying that it is due for a correction. The returns of 10-15% you see over long time periods in the markets, however, are due to just a few short periods of time when the market was on fire. Take those away and your return will drop drastically. If you are close to retirement you should be building up cash for the money you’ll need right away in any case. If you are a long way from retirement, you need to just sit tight and accept that there will be some drops in value along the way. If it makes you feel better, hold some of your contributions in cash and wait for a dip if you feel the markets are really frothy. It is probably a better strategy, however, to wait for the dips and then increase your contributions for a period. In any case, make sure you stay almost completely invested so you don’t miss the big moves.
4) Having a lot of your money in single positions. It is a really bad idea to have more than about 10% of your funds in a single stock, bond, or other asset. (Having them in a single mutual fund is different since the fund is invested in many companies.) The most common time when this occurs is when a company gives out shares of its own stock as a matching portion of a 401k, as a bonus, or as another means of compensation. You might work for a great company, but shed the shares as soon as you can. You don’t want to lose your job and see your retirement account devastated the same day.
In the next post I’ll talk about the small mistakes that people make when investing in retirement accounts and mutual funds. Avoiding these mistakes can increase your returns and help you end up with a few million dollars more at retirement, but they aren’t as important as avoiding the big mistakes.
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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.