It’s your first job. You’re thinking about happy hour with coworkers, homework free evenings and complete independence from your parents. The last thing on your mind is retirement, but it should rank very high on your priority list. The sooner you invest, even if it is just a small amount, the larger a nest egg you will have when you reach retirement age.
Many might think that with the economic crisis the nation is experiencing, they should hold off on beginning their 401(k) contributions until the market turns around. They couldn’t be more wrong. One of the basic tenants of investing is ‘buy low, sell high.’ Usually you can’t be too certain whether a stock is going to rise or fall; but with the circumstances now, we can be reasonably certain that stocks are getting near their bottom.
Stocks have much more room to rise than fall at this point. It may take a couple of years for the market to completely recover, but recover it will, and you will have found that you began investing at an optimal time.
What exactly is a 401(k)?
A 401(k) is a retirement savings account that uses employees’ pre-tax dollars to make investments that will be withdrawn upon the participant reaching a certain age. The employee is able to choose from the variety of funds that their employer offers. These mutual funds will cover many different areas of investments – domestic equity (stocks), fixed income (bonds), international equity (international stocks) and, sometimes, alternative investments (hedge funds, etc.) The money that each person invests in a particular fund is then pooled with other employees who choose the same fund.
Where should you invest your money?
The most important thing to keep in mind when initially investing is to diversify. Proper diversification will make your portfolio both more successful and safer. Diversification enables you to limit risk by exposing the portfolio to many areas of investments so that in the event that one particular investment performs poorly, your overall portfolio is not severely affected.
The first thing to do when choosing 401(k) investments is to decide how much to invest in particular types of investments and then choose funds to fit those categories. The most common options are fixed income, domestic equity, and international equity. Sources such as Investopedia.com and Yahoo Finance are quick and easy places for you to learn about these different investments. After you know the basics, you can choose how much of your money to direct to certain areas based on your personal choices and circumstances.
Risk vs. Reward
As time goes by and life circumstances change, your investments should also change. The younger you are, the more you are able to weather the volatility of riskier investments. These riskier investments (e.g. Small-Cap Equity or International Equity) are the ones that will bring your portfolio the largest gains in good economic times. In the event of a market downturn, these will suffer the largest losses but you will have enough time before retirement to make them up.
In your 20s, most, if not all, of your investments should be in riskier investments like Domestic Equity and International Equity in order to gain growth in your portfolio. The general purpose of most Fixed Income investments is to protect your principal investment and keep pace with inflation. You will not see significant growth from these investments. The closer to retirement you get, the more important it is to protect what you have, instead of trying to grow the investments.
Monitoring your investments
As long as you have money invested, you should be actively monitoring it. You will receive quarterly statements with a snapshot of how your funds have performed and what their value is now. When you receive your statement, spend a little time really reviewing the funds. Use online resources (Yahoo Finance, Investopedia.com, Morningstar.com) to update yourself on the fund.
If one or more of your funds is doing poorly, fight the urge to automatically sell all of your shares. Not only could you be getting rid of a good fund that may have just had a bad quarter, but you may also incur fees you didn’t expect. Most 401(k) plans will charge you a fee to sell/buy shares of a fund.
Do some additional checking to see if you can learn why the returns were not what you had hoped. As you watch your funds over time, if you find news that seems like it will lead to long term trouble (There are rumors of a bankruptcy, etc.) then it may be time to sell and choose a new fund. Also, if you find that the fund is consistently, quarter after quarter, not doing as well as similar funds, then this may also be a good time to bid it farewell.
Making sound investment choices does take time and effort. But following these steps from the creation to the maintenance of your 401(k) will ensure that you have a good nest egg for retirement.