Often people ask our retirement plan advisors: "What is the best way to invest in my 401(k)?"
While many companies provide 401(k)s as a benefit to their employees, the frequency that we hear this question is alarming. This question underscores that many 401(k) participants haven't had enough education from their 401(k) plan providers to know how to fully participate - but the stakes couldn't be higher. Once you have worked through your higher income years and reached retirement you will not get a 2nd chance. Either you will have prepared properly - or not. In our opinion, however, there are tried and true methods for investing in any 401(k). We've seen many investors achieve a positive and profitable long-term investment outcome by following a few guiding principles.
1. Retirement Planning: The Long-Term View
People can mistakenly believe that the key to investing is being able to pick the next winning stock. The truth is that being able to reliably and consistently choose the next big winner and the next one after that, year after year, is virtually impossible. At best, this sort of investing relies on luck -- which is no way to plan your future.
In reality, successful investing can be somewhat mundane. Smart financial strategies recognize that smart investing should be a long-term proposition. It is the compounding of your returns over long periods of time (10, 20, 30 years or more) that truly accelerates the growth of your investments.
2. Make Consistent and Steady Contributions
Many times I’ve heard folks say “I want to save up a small chunk and then invest”, or “I’m really tight on money right now, so I’m going to hold off”. When it comes to saving for your retirement, however, your number one ally is time. The sooner you begin making contributions to your retirement the better off you will be when the time comes to depend on your savings.
In addition, many employers match contributions to a 401(k) plan, meaning that you could be missing out on significant additional contributions to your plan if you are not making any yourself. At a bare minimum, participants should be contributing enough to receive matching employer contributions. If not, you are essentially leaving free money behind.
Finally, contributions to a 401(k) plan are tax deferred; meaning that the income tax you would otherwise pay on the funds goes into your account. This, in turn, further enhances the growth potential of your account.
3. Don't Overlook the Importance of Diversification
We have all heard the adage about not putting all our eggs in one basket. The warning refers to the risk to all the eggs if you drop the basket. The same is true when it comes to investments. By putting your retirement nest egg into a select few stocks or funds you greatly increase your financial risk. Conversely, putting your eggs into various baskets intuitively makes good investment sense.
Diversification, however, means more than simply having numerous stocks or funds. The key to diversification is to have non-correlated investments. In other words, you want to include investments that perform differently and do not typically move in the same direction in your portfolio. For example, investing all of your money into hundreds of different bank stocks will not achieve the goal of diversification if the banking industry goes through a difficult time as was the case during the recent recession.
In practical terms, this means you should include exposure to different asset classes in your portfolio such as large stocks, small stocks, growth stocks and value stocks as well as international stocks, emerging market stocks, short-term bonds, government bonds and corporate bonds. Rarely do these different asset classes all move in the same direction at the same time. A properly diversified portfolio should lower your risk while still capturing an overall positive rate of return from the combined asset classes.
4. Managing Costs is Crucial
One of the biggest factors that investors frequently ignore is the cost of investing. Part of the problem is that proper and full disclosure of costs has not historically been the norm. Furthermore, the variety of costs come with a bewildering range of names such as internal fund fees, investment management fees, commissions and 12(b)(1) fees, along with account fees, front-load fees, back-end loads, no loads and transaction costs just to name a few. It is no wonder that investors and plan participants are confused.
It is not uncommon to hear retirement plan participants say “I don’t pay anything” or “My employer pays all the costs” or “I don’t know what I pay”. However, the reality is that everyone pays some costs even if they realize it or not. For, after all, service providers must be paid for the work they do.
Now, here’s the important thing to recognize – the higher the costs, the lower the potential returns. With lower potential returns, you will need to invest more, or plan to invest longer, to reach your retirement goals. Make it one of your goals to understand what costs you are paying. With most medium size plans your overall costs should run around one percent. Smaller plans will typically include higher costs, often approaching two percent, while participation in much larger plans should mean that costs are kept below one percent.
While actively participating in a 401(k) can dramatically increase your chances for a successful retirement, there are many aspects of every 401(k) that deserves ongoing attention. In the next article, Ask a 401k Advisor: 7 Keys to 401k Success (Part 2), we outline other areas that we feel are also important to keep in mind.