Last night a friend invited me over to talk to his 23 year-old son about 401k investing. He had recently started his first career-type job and was unsure what to do when faced with the packet from human resources. With the help of his father he had initially enrolled in one of the target retirement funds, which is not a bad idea when you’re still learning and trying to get your bearings. The issue, however, is that you can give up some return by being over-invested in income securities (bonds) when you’re too young with many of those funds. You can do a little better by selecting funds yourself with just a little bit of knowledge. Some things we discussed are:
1. The most important thing is to get started while you’re young. Every dollar you invest when you’re in your early twenties will be worth about $130 when you retire. Every dollar you invest at 30 will only be worth $60 at retirement. A dollar invested at 40 will only be worth $16 at retirement, and dollars invested in your fifties may be worth $2-$4 at retirement. This means that if you can put away $10,000 during your first year of work, you’ve created $1,300,000 for yourself at retirement. Do the same when you’re 40 and you may have $160,000. Big difference.
2. Your first goal should be an emergency fund. People build expenses and obligations – like car payments – until they consume all of their available income. This means that when something happens like your car breaks down, out comes the credit card and you have very little extra income to pay down the balance. Do this a couple of times and you’ll soon find yourself struggling just to make the interest payment each month. Put away $10,000 in cash into a money market fund as soon as you can and only use it for emergencies. When you need to dip into it, make it your top priority to replace it.
3. Try to put 10-15% away among your 401k, IRA, and other retirement accounts, even if you have a company match. He had a fantastic 2-for-1 match from the company, so he decided to only put 5% away. With the company match he was certainly saving plenty for retirement. The issue with relying on the company math, however, was that (again) you tend to spend any extra income that you have and add obligations, leaving you with little free cash flow. This means that it is really difficult to put away more later if your company should stop providing the match. It is better to invest more yourself and then take the company match as gravy in the top. If you end up at 45 with way more money than you need, like you pass $1 M in your 401K and still twenty years to retirement, you can always cut back on contributions then and use the extra money to help pay for your kids’ college tuitions.
4. Use raises and bonuses to increase your investments. You may find it hard to put 10% away right when you start, or you may already be trapped because you started to invest too little and now don’t want to cut lifestyle to raise cash. One strategy is to use raises to increase your investments. For example, if you get a 3% raise, increase your 401k investment by 1% a year and spend the rest. That way you don’t miss the money. You can also use bonuses to make extra contributions into your IRA.
5. Avoid bonds while you’re young. It is true that bonds (and other fixed income securities) will help smooth out the ride because the dividend/interest payments will help support the price of bonds and dividend paying stocks during market swoons. Still, over long periods of time, growth stocks will return a few percentage points per year more than bonds and mature stocks. I would therefore stay away from bonds until I was at least in my mid-forties, and maybe even fifties. Of course, this all depends on your personal ability to withstand volatility. I would also start raising cash as I approached retirement rather than expecting to rely on income from bonds and stocks only.
6. Over periods of ten years or more, returns of 10-15% can be expected. While there are many ups and downs over short periods of time, like a few years, if you hold a basket of stocks for ten to fifteen years, you should expect returns in the traditional range of ten to fifteen percent, meaning you money will double about every five or six years. So if you invest a lump sum the first year, in fifteen years you should have about eight times that amount. Don’t expect to necessarily have twice what you started with after six years, however. You may have more or less since there will be great years and bad years.
7. Diversify in large caps, small caps, and international. Large caps are large companies; small caps are small companies; international stocks are just that, companies in non-US markets. By putting some money in each of these areas, you will be sure to be in whatever is growing at the time. I would probably put about 35-45% in large caps, 35-45% in small caps, and 20-25% in international. I might also put some money (10% or so) into a REIT fund if available. If there is an emerging growth fund or another high flyer, I might put 5% in, but not more than that. I would tend to favor small caps because they will do better over longer periods of time, and I might mix some mid caps (medium stocks) in with the small caps just to add a little more diversity. Fewer mid caps will fail than small caps since they are a little bigger and better able to weather economic storms. If I wanted less volatility, I’d shift more towards large caps.
8. Pick funds with the lowest fees. Use index funds if available. Really all mutual funds will end up with baskets of stocks that will perform about the same. This means that the funds that have the lowest fees will win out over time. Fees are a constant suck on your returns and only make the fund managers wealthy. Look for funds with expenses and fees of less than 0.5%. If you can find those with fees and expenses under 0.25%, you’re really doing well. Stay away from those with fees and expenses above 1% unless you have no other choice.
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.