When I first began investing, I was completely lost. There were so many names, acronyms, and terms that I had never heard before. Like so many families in America, mine didn’t talk about things like investing and money. I had no idea how to start, and as a result I made some silly mistakes. This post will be geared toward someone like myself when I was starting my career: young and naive, but willing to learn. I want to talk about my favorite investment vehicle: The 401k.
Let me kick off this post with an embarrassing story. When I turned 18 in 2007, I was stoked to start making the big bucks in the stock market. I had seen the 1987 film “Wall Street,” and I just knew that I could make it big by trading stocks. I had saved up $1,000 by working a couple of summer jobs, and I was ready to turn it into millions. So, I opened up a Scottrade account online and dumped all of my money into one stock that I knew was going to take off. After all, it had been paying dividends for decades, so what could go wrong?
That company? American International Group Inc., or AIG for short. For those of you who don’t remember what happened to AIG shortly after this purchase, let me remind you:
That’s right, the one stock that I chose to pour all of my hard-earned money into was rocked by a scandal that precipitated the financial crisis of 2008. It was literally one of the worst investments I could have ever made, and I lost everything. Thankfully, it was just a $1,000, but it taught me a hard lesson. If I was going to invest, I needed to do it in a smarter way. If you are lucky enough to have a 401k plan at your work, then this post is for you.
The Power of Automation
One of my favorite things about the modern era is that we are able to automate so many of the tedious things in life. Almost all of our recurring monthly bills are set to auto-pay, which leaves so much more time to do the things we enjoy. The same applies to retirement savings — having it automatically invested every paycheck is one less thing you have to do on a regular basis.
But automation serves another purpose. In my case, it frees me from temptation. I never see the money show up in my bank account, which means that I will never have the chance to spend it on frivolous things. I know that I cannot trust myself to make sound financial decisions 100% of the time, so removing temptation is a powerful tool to ensure wise investing strategy.
One of the best ways to make your investing dollar go further is to reduce your overall tax burden by investing in tax-sheltered accounts. Basically, these accounts allow you to invest money before it is taken by Uncle Sam, which in-turn reduces the amount of taxable income you have to report. This is a wonderful incentive given to us by the Internal Revenue Service that encourages financial responsibility. Of course, there are limits. Each person can invest a maximum of $18,000 per year into each pre-tax account. Still, this comes out to a lot of savings in money that would otherwise go to taxes. Our marginal tax rate is currently 28%. For every dollar that we invest in our 401k accounts, we keep 28 cents that would otherwise go to the tax man. That adds up very quickly.
In order to avoid the financial disaster that I discussed earlier, diversification in your investments is key. Putting all your money into one investment is dangerous, and it can lead to financial ruin.
Most 401k accounts will offer up several low-cost funds that come with a passively-managed bundle of holdings. These funds look and act just like regular stocks, but they are a mix of several companies. The concept is very similar to a mutual fund, a group of stocks that is actively-managed by a fund manager. The problem with mutual funds is that they are rotten with high fees, and the returns generally do not outperform the general market.
If one of the companies in the 401k funds fails, it is highly unlikely that the whole fund will collapse. This is a great option for the new investor. It allows you to enjoy the benefit of a well-diversified portfolio without having to do all the legwork yourself. The fact that it is passively-managed means that fees are low as well, making it a very attractive option.
100% Return on Investment
And finally, my absolute favorite thing about the 401k: the employer match! Most companies that offer a 401k to their employees will offer some kind of contribution match. In my case, my employer offers an equal match for up to 5% my of income. I will make $82,147 in salary this year. 5% of that salary would be $4,107, which my company would then deposit into my account as well. I view this as an instant 100% return on investment. If you were to make a return of 8% every year on your investments, it would take 9 years before you could double your money. With the employer match, that growth becomes so much faster.
If any of you newer investors have any questions or comments, please leave them in the section below. If you are a seasoned investor, we would love to hear your advice. As always, thanks for reading!