How Do I Invest in a 401K?

glassjellyfishSo you’ve just started the new job and the HR department handed you a form to start a 401K account.  Many people miss the old pension systems where all you did was work and then the company would give you a fixed payout for life when you retired.  It required mo work on the part of the employee, other than possibly signing up.  The returns on these plans, however, tended to be in the 6-8% range if you were lucky.  With investing on your own in a 401k, you can do better – much better.  Stock market returns average in the 10-15% range.  Over a period of forty-five years, this could mean getting payouts of $250,000 per month rather than the $60,000 you might get from a pensions.  Also, when you die you’ll have money to leave your children while the pension will vanish when you and your spouse die.

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.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on investment strategies, stock picking, and other matters relevant to the investor. 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.

One comment

  1. Reblogged this on How to $tuff Your Pig and commented:
    If your employer offers a retirement plan (any plan), please don’t pass it up! Check out this post “How to Invest in a 401K” from The Small Invester.

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