Starting Your First 401K
A couple of friends asked me for advice on this topic, so I collected my thoughts and turned them into a blog post. This input is general by design. I want to make it helpful to the largest possible group.
What this article is not: deeply detailed, time-sensitive advice or stock tips. I am personally wary of that type of opinion, but there’s plenty of it out there if you want it.
What this article provides are basic principles that a novice can understand, but that anyone can apply. I believe in keeping investments simple, so you don’t get in your own way or lose sight of what you’re trying to accomplish. This advice is meant to help people grow their money throughout their careers, not to get rich quick.
Why Should You Contribute to your 401k?
There are basically four reasons:
- To gain whatever money your company offers to match in your 401K contributions. Basically, if you don’t get this money you’re not getting your full paycheck. More on this later.
- To save money for your retirement. In general, people tend to be better at thinking about life in the short term. Planning for retirement can be difficult because it’s not an immediate problem. if you instruct your company to regularly contribute a percentage of your income to your 401k, the savings becomes automatic, and this can help you save for the future, without having to be consistently vigilant.
- To get tax benefits. The government wants to encourage people to save, so it will let you defer the taxes you would pay on your 401k until you elect to receive your benefits. This can translate to a large savings, because if you pay for the gains of your stocks when you are retired and not earning an income, you will have less of a tax burden. This will matter more as you earn more from your investments.
- To diversify away from cash. The value of cash tends to go down. We tend to forget about this, because for close to a decade the US has experienced a lower than normal inflation rate. But, over time, inflation tends to average about 2% a year. That means cash loses value over time. Assets like stock mutual funds and bonds usually grow (or “appreciate”) in value. US Stocks have tended to increase in value an average of 6 – 7% a year. So, to get access to those earnings and to avoid losing money from inflation, it makes sense to have some of your savings in non-cash assets. We will discuss which assets in our next section.
Asset Class Matters Most!
You may be presented with what seems like a dizzying number of options in your 401k plan. There will likely be several funds available and you will almost certainly not have heard of any of them. Don’t panic. The big decision is not which fund(s) to pick, it’s what asset(s) to buy.
In the interest of simplicity, there are just three basic types of assets: cash, stocks and bonds.
Cash you know about already. A stock represents ownership of a small part of a company, one that you hope will grow and be profitable. Groups of stocks are combined into mutual funds and offered to you in your 401k. Bonds are debt that you can purchase. Bond funds are collections of bonds packaged into one bundle. The bonds in your 401k are likely to be debt owed by governments or companies.
The performance among these three asset classes will vary widely depending on what’s going on in the economy; at the same time, the individual assets in any given class will be affected by the same forces. This means the difference between the best and the worst mutual fund is unlikely to be as big as the difference between the average mutual fund and the average bond fund.
What Asset Class Should I Choose
This question is, of course up to you. It comes down to an evaluation of risk versus return. Mutual funds generally have higher returns than bonds or bond funds do, but they sometimes go down. Bond funds have lower returns, but they’re less likely to go down and, more importantly, when they do lose value they are likely to lose less value than do stock mutual funds.
How do you decide how much risk to tolerate? Generally the younger you are, the more risk you can afford to take. If the mutual funds you choose go down, you are more likely to make that money back because you have more time to wait for them to regain value. If, however, you are nearing the end of your career, you may want to be more cautious, because you will need to use that money soon and don’t have as much time to let it recover if the market does go down.
How Much Should You Put in?
If your company offers a matching contribution, you should put in as much as the company is willing to match. Because any time you don’t invest the entire amount the company will match, you are giving money back to your employer. If your pay is $100 a day and your employer offers you a 2% matching contribution on your 401k, your pay is in fact $102 a day. If you don’t put in your own 2% to be matched, you will be leaving the money on the table.
The only time when I would not recommend putting in as much money as your company will match is when you have debt on which you are having trouble making your payments. You should absolutely continue to contribute to your 401k if you are able to pay your debt each month and continue to live comfortably, especially if there’s a matching contribution.
Which Mutual Fund Should You Buy?
If you are not immediately going to retire (say
a year away or more) you will almost certainly want to have some mutual funds in your 401k. Here’s an easy way to think about which to pick.
The current popular wisdom is to avoid costs as much as possible. One way people do this is by using an “Index” fund instead of a managed fund. I’m a fan of this, myself. An index fund generally follows the market. If you are just starting investing, I would suggest that you consider starting with a fund that mirrors the performance of the S&P 500 or another index of large American stocks. This fund will be low cost and offer you a reasonable amount of diversity.
If you are just starting out your savings and have less than about $10,000 in savings, I would suggest that this is likely as much as you need. There’s no reason to spread that amount of money over a bunch of funds, it’s likely to only add unnecessary complexity. If/when you are able to save $30,000, I’d consider adding a small cap fund of American stocks and an international fund. In choosing these, you should look at their past performance and as I said earlier, their costs, but, remember, don’t worry too much about trying to pick the very best of these, you’ve already made the most important decision when you decided what asset class you picked. If your savings grows beyond $30,000, it will be time to consider more diversity including bonds and other mutual funds. That said, the funds you started with should still be three key pillars of your savings.
Any Additional Pointers?
Keep it simple and consistent. People, on the whole, tend to be swayed too much by fads and recent news. When you are investing there are costs associated with moving money around and switching assets, both in terms of the transaction itself and in terms of your time. In fact, female hedge fund managers were likely to deliver higher returns than their male counterparts precisely because they made fewer transactions and incurred less cost rather than chasing after hunches. Therefore, it makes sense to make a plan and stick to it. Remember investment in your 401k should keep working until you retire. You should be thinking on a long-term time horizon.
As to why to keep it simple, if you add too many funds, it’s easy to become overwhelmed or have difficulty evaluating your performance. Your investments should be providing you “passive income.” If you spend more time on them, there’s not good evidence to show that your time will necessarily result in more earnings.