401(k) investing for dummies

People talk about the stock market being risky. I see risk as running out of money halfway through your retirement!

If you withdraw $50,000 per year starting at 65, at only 3% inflation you would need to withdraw $75,600 at age 80 to maintain your standard of living. At 90 you are looking at taking out $101,600! Are you going to have enough to comfortably live in retirement? Or are you going to spend your golden years working part time under the Golden Arches to supplement your income?

An argument I've heard is that you need much less income to live on once you retire -- 70% to 80% of what you earned will be enough.
I say, ummm, no.
You will likely not have a company health plan to subsidize your costs. Taxes will almost certainly be higher in the future (remember that lovely economic stimulus check you received a month ago? Guess how long we'll be paying off those billions of dollars?).
And guess what? You're retired – no job to suck up 8 hours a day. What will you DO in those hours and days and weeks? Travel? Hello expenses! Golf lessons? I hope you are friends with the local pro. Nearly anything you do will involve higher leisure expenses

To combat all this, how would you like to add a couple percentage points of annual return to your 401(k) investments? Read on!

Let's get a few facts straight about 401(k)s, mutual funds, and market tendencies before getting to the meat of the post.

401(k):

• In your 401(k), you have a select group of mutual funds that you can contribute to.
• You may also have the option to buy your company's stock. (This post will deal with only the mutual fund option)
• You can change how you want future contributions allocated across the various funds (you may have conditions on this; once a month, once per year, etc.)
• You can also transfer existing money between funds. There may be conditions on this option too – recently many funds have started charging fees if you transfer money out within a month or two of having moved the money into the fund.

Mutual Funds:

• Mutual funds are basically group investments. A group of investors pool their money and it is professionally managed. The positives for the group is that they do not have to micro-manage their investments, costs are shared amongst everyone, and the professional money manager has greater information (usually!) and resources available to find potential investments. The negatives are that most funds tend to NOT do quite as well as whatever base or index it is measured against, and that fees can sometimes be quite high.
• Funds have rules about not putting all their eggs in one basket – they have to be diversified.
• Most mutual funds available through 401(k)s are grouped by whether they are stock funds, bond funds, or cash (money market) funds.
• Money market funds (also known as cash or GIC funds) keep all money liquid and available, and only earn whatever the prevailing interest rate is.
• Bond funds are divided into the duration of the bonds bought and by the relative safety of the bonds. Typical durations are short, medium, and long term, while safety ranges from government insured to corporate paper to municipal (or general obligation), to high yield (or junk) bonds.
• Stock funds are divided into large, middle, or small cap depending on the size of the companies they invest in. They can be domestic, regional, or worldwide. They are also typically segregated by the style they exhibit – value (under priced to what they should be worth), growth (strong earners), or mixed.
• Some funds are specialty – they deal with an index, real estate, technology, health care, or dividend stocks exclusively.

Tendencies:

• Stocks tends to be cyclic, like waves. However, the general tendency is for each succeeding crest to be higher than the prior wave.
• Over time, the stock market tends to return the highest returns. Bonds are next, and then money markets.
• These higher returns are over the long term – usually periods of 10 years or more.
• Inflation averages around 3% -- and this government-stated rate is less than the real rate experienced by people living normal lives. Housing and college costs, for example, were taken out of the calculation back in the 1980s! I would submit the real rate people face is closer to 4%, when the recent increases in energy and health care are factored in.
• If bonds return around 6% on average, after inflation you only see a 2 or 3% real return!
  With increasing life expectancies and better health care, a worker retiring at age 65 in good health needs to plan to have retirement income for at least 30 years!

Since over time, stocks give you the highest returns, and you need to have your money working for longer than ever, I don't see why most people should not be nearly 100% in stocks.

The standard argument for diversifying over different classes is that as one type under performs, other types over perform, and thus the risk is reduced. I think I covered my point of view on risk at the beginning of this article!
The other argument I've heard as to the benefits of diversification is the psychological one. People are not good investors – they see their holdings going down in value and they sell. In essence, they have bought high and sold low. Then when the market starts booming, Johnny-come-lately plows his money back into the latest technology fund to start the cycle all over again. My response to this argument is 1) the person reading this is hopefully not the average person, and 2) a little willpower and a plan helps to inure oneself against temporary losses.

So, point number one to add sizzle to your annual returns is to be invested almost totally in stock mutual funds. Remember – this is advice only for 401(k)s, where you have only mutual funds available to you, and you are by definition “in it” for the long term. My target is 90% for everyone that is more than 10 year away from retirement, and 80% for those within that 10 year span.
Which funds? We'll address that in a future post – but in general a breakdown of 30% foreign stocks, 30% “total stock market” indexes, and 20 – 30% mid-cap or value funds is sufficient. If you have a choice between similar funds, make sure you invest in the one with lower annual fees!
The remainder (10 – 20%) of your contributions should be into medium term, medium risk bond funds. You want something that will beat inflation but not (again, over time) run too much risk of negative returns.

Now for the second ingredient for red-hot returns: remember how the stock market goes up and down over time? We are going to modify the old bromide “buy low and sell high” to simply, “buy stock funds low.”
As a general rule, look at the charts of the S&P and the NASDAQ 4 times a year, in Feb, May, Aug, and Nov. If either index is down 10% from where it was one year prior, then put in an order in your 401(k) to transfer 10% to 20% from the bond fund into the stock funds. (If you have less than 10 years until retirement, move 10%, otherwise move 20%.)

And that is it! You are taking advantage of the cycles and also taking emotions out of the process. When the stock market is doing well, you're hoarding some money in reserve – and when it tanks, you're buying low. Call me in 30 years and thank me.

Regards,
Trond