Five Common Mistakes When Investing in your 401k

With more and more companies going from defined benefit, or pension plans, to defined contribution, or 401K plans, individuals are finding themselves needing to determine how to save and grow their money for retirement themselves.  Fortunately, this is actually a lot easier than you would think.  Simply contribute equally to 3-5 funds and you’ll do well.  Pick funds that have the lowest fees available and you’ll do better.  Index funds tend to have the lowest fees available, so pick those if they are available to you.  Pick funds that invest in different segments of the market (for example, small caps, large caps, growth, value, international) and you will do better still.  Finally, rebalance the funds about once per year so that you have the same amount in each fund and you’ll be on track to maximize your returns.

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While it may seem daunting to some, having a 401k plan instead of a traditional pension plan and therefore being able to manage and control your money has benefits.  A big one is that you don’t run the risk of being thrown into the government pension pool should your company go bankrupt or not contribute enough to the pension plan.  Likewise, you can choose where the money is invested rather than being at the mercy of a pension fund manager.   Also, often you will find that the rate of return you can receive will be greater when you invest for yourself and are invested all in stocks than you will get from a traditional pension plan.  Realize that a pension plan needs to set the payout level where they know they can hit it, meaning it will be below what the think they can make through investing. Change companies? All of your money can go into an IRA and go with you rather than sitting in a pension plan at a former employer. Finally, when you are ready to retire you will have all of the money available at once, rather than getting a monthly or yearly check from the pension plan.

There are some things people do, however, that can spell disaster for a 401k account.  Here are six:

Not Investing Enough:  In order to have enough saved for a comfortable retirement, you must put away enough from each paycheck.  A good rule of thumb is to put away 10-15% of your take-home pay.  Note that this is your contribution, without counting the contribution of your employer.  A good strategy is to put enough away to receive the full company match, then fund a standard or Roth IRA, then put anything additional left over into your 401K up to the maximum.  If you still have more money left (lucky you) just invest in a standard taxable account.  Note that investing early means a lot more than investing later, so start off investing as much as you can right when you start your first job. 

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Keeping Too Much in Cash:  Some individuals are scared of investing in stocks and therefore leave the money in a money market.  Money market funds will pay a few percentage points less than inflation, so each year you are actually losing money.  While stocks can move up and down, over long periods of time (which is what you have when saving for retirement) they will outpace inflation by several percentage points.  The difference between a 401K filled with stocks and one filled with money market funds will be millions of dollars.  So, take the plunge and invest.  If you are nervous, just don’t look at the balance more often than every five years or so – things will be fine on autopilot. 

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As you get closer to retirement (within 10 years or so), start to move money into cash such that you have about 10 years’ worth of cash in a money market when you are ready to retire.   This will prevent a sudden market drop, as was experienced in 2008, from affecting your retirement plans since you’ll have enough cash to not need to touch your investments until they’ve had time to recover.  Note that all of the losses from 2008 were erased by the end of 2010.

Trying to Time the Market:  It can be scary to listen to the commentators at times.  They will often talk about a slowing of the economy or overheated markets (read Alan Ableson’s column in Barrons and you’ll be ready to slit your wrists).  The trouble is, most big market moves occur in very short periods of time.  If you pull your money out and miss a big move upwards, your return will be far less than it would have been if you had left things alone.  While it can be tempting, trying to time the market and pull funds out just in time is a bad idea.  Just let things be.  If it makes you feel better, increase your contribution amount during market dips.

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Concentrating in One Area:  Like trying to time the market, some individuals think that certain areas of the market will do better than others.  Just remember that everyone else has the news that you have.  If a market segment is hot, the prices will have already risen there to account for it.  It is best to just spread your money out over several different types of stocks and market segments.

Keeping too much in Bonds:  The percentage you hold in bonds should be no more than your age.  For example, a 20 year-old should have no more than 20% of her savings in bonds (with the rest in stocks).  While it may seem safer, once again you’ll be cheating yourself of a lot of return if your bond mix is too high.   A little bit of cash also makes up for a deficiency in your bond mix (a 60-year old with 10 year’s expenses worth of cash and the rest in stocks is just as safe as one with 60% bonds).

Taking money out:  This is probably the worst thing one can do – withdraw funds before retirement age.  Some see their 401K as found money, taking out funds to pay off credit cards, buy a house, or just spend the money. Not only do you pay a huge penalty for doing this, each dollar you remove in your 20’s will result in the loss of about $128 in retirement.  That $10,000 you took out to pay off credit cards just cost you $1.28 million!  Live within your means and let your 401k grow.  Unless you will be thrown out on the street if you don’t, there is no reason to remove funds from a 401k.

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Likewise, taking a loan against your 401k is also a bad idea.  If you end up leaving the company (on purpose or involuntarily), that loan will become due at once.  If you lack the money, you will be penalized.  If you need to borrow money, see a bank, not your 401K.

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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.

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