What is the best way to start investing—is it a 401(k)?
Fantastic question, and, yes, the 401(k) is the best way to start investing more often than any other way. By far the biggest and most important investment goal is retirement—people need to replace nearly 100% of their working income when they retire, which is an enormous goal. About 75 million americans or just under 50% of the working population have a 401(k) or similar defined contribution plan where the employee is responsible for contributing the money that builds toward retirement. Old-school defined benefit plans where the employer has this responsibility are on the decline.
Let’s be clear though. I am not endorsing the 401(k) just because it is common. I think it is well-designed too.
What do you like about them?
First and foremost, the 401(k) or similar 403(b) is simple and automatic. Everything we know about long-term investing says those are huge advantages. The more complicated and optional it is to sock away your money, the less likley you are to do it. With a 401(k) you set your contribution level, you choose your investments, and then that’s it until you change it.
Second, the 401(k) is tax-advantaged. You contribute money before taxes and it grows without being taxed until you withdraw it. That’s a double bonus. It lowers your tax bill right now, and because your nest egg builds tax-free, it grows faster than an account on which you pay yearly taxes.
Third, many employers match your contributions, at least up to a certain level. The two most common matches are dollar-for-dollar and 50 cents on the dollar. Half of employers use one of these two matches. For an example of how valuable this is, say you make $50,000 per year and contribute 5% of your income, $2,500, to your 401(k). If your employer matches dollar-for-dollar, you will get an extra $2,500. This is *free money*!! You don’t have to work harder, better or longer, you just have to invest. I have said before you have to be crazy not to want that money.
Is that amount enough? What is the right contribution level or how can you decide on your own best contribution level?
You probably know what I am going to say—max it out if you can!! in 2012 the maximum you can contribute is $17,000 per year or $22,500 if you are over the age of 50. That is a stretch for many, many people, so think of it as a goal—someday.
Now let’s go to the other end, the bare minimum in my book. As I just mentioned, workers really should invest at least what is necessary to get the company match, the free money. There aren’t great statistics on what that typically is, but 5% is common.
So, finally, the ideal range I usually cite is 6% to 8%. It is big enough to build a big nest egg and small enough to be do-able. And the statistics show it is fairly common. A recent poll showed 8.2% as the average contribution rate.
Now that I know how *much* to contribute, where do I put it?
Yes, the million-dollar-plus question!! How do you pick the best investments within your 401(k)? It’s a very complicated question, because everyone has a different 401(k) menu and different risk tolerances and needs. I will concentrate on two big mistakes and two things to look at:
One big mistake is being overly cautious. A lot of people go for things they think of as “low risk” meaning not volatile or not likley to go down in a bear market. But a *huge* risk is not having enough money to retire—meaning you don’t want to underinvest in stocks. The Aon Hewitt study showed across ethnicities the average is around 70% stocks. If you’re below that, you should readdress the issue.
Another thing is: don’t chase the hot dot. That means you don’t want to overly invest in whatever the latest thing is. Whether it’s gold and emerging markets now or technology and large cap growth in 1999, people tend to pile into the thing that has done well already. Hot streaks do not last forever. The best investment over the last few years is generally not going to outperform the next few.
What *should* you look at? Fees. Expensive funds tend to underperform. It’s just math. Fees come out of total returns, and the more you pay in fees the harder it is to make up for them. You can easily find a fund’s expense ratio in your 401(k) packet, or online at morningstar.com, Google finance, or Yahoo finance. If you are paying more than 1.10% in large caps or 1.25% in small-caps, There needs to be a reason why.
Finally, when trying to judge how good a fund is, look long-term. At least ten years and preferably over the life of the fund. One year and three years are not long enough in most environments.