Investing is the most challenging aspect of your financial management. How much do you invest? Where do you invest? When do you invest? When do you divest your holdings are all concerns that are not easily answered.
The choices are endless and frankly it is easy to make the wrong decision. There are so many potential products to invest in: Stocks, bonds, mutual funds, IRAs and Roth IRAs to name a few.
Where do you start? Keeping in mind the primary objective to investing is to provide yourself with a return on invested dollars, meaning you should get back more than you put in.
Your first place to look is at work. If your company provides an option to participate in a 401K program that matches any of your contribution, this is likely a great first step in investing.
Some companies will contribute as much as 50 cents for every dollar you save. Usually there is a maximum limit like an equivalent of 6% of your income. These terms vary widely so please check with your human resource manager.
This means for every $100 you invest, your company would contribute $50. That is a 50% return on your investment. Compared to the average return on investment for the S&P 500 from 1968 to 2008 was only 5.93% you are already in great shape. Its free money! By not participating it is like saying no to a raise.
The other great advantage of a 401K is that all contributions within yearly limits are tax deferred. Deferred means that you will pay taxes but not until the funds are distributed when you retire. As long as you leave your money in the 401K account it will continue to grow as an investment and the government won’t touch it. Conceptually, when you retire you will likely be taxed at a lower rate than while you are working. Taxes will be due only as you withdraw money from this account.
Your company doesn’t offer a 401K? Are you and educator or work for a non-profit organization? If so there is a similar plan available to you called a 403b that an employer may offer with or without matching contributions.
If neither a 410K nor 403b is available to you, the next options are Individual Retirement Accounts (IRA). You will have the option of a “traditional” IRA or a “Roth” IRA. These also provide tax benefits and will be reviewed in the future on this blog. The primary difference is that with a traditional account the money you contribute will be exempt from income taxes today and distributed tax free when you retire, while with a ROTH the contribution today are taxed but will be distributed tax free in retirement. With IRA’s however there will be no “matching” contributions from an employer.
Now, once you have money in a 401K you must decide where it is allocated. Most 401K’s have several options including a “cash” or “Money Market Account” fund. MMA funds are pooled investment funds that provide little risk, but also very little return. These funds invest in income producing bonds of highly rated and sound companies to assure preservation of your capital.
You may also have several mutual fund options. These are often challenging to decipher. Before deciding on any one, obtain a copy of their prospectus. It’s usually painfully dry reading but imperative to making a good choice. Most marketing material and summaries that are easily available do not contain the detail or list all the fees that must be documented in the prospectus. Take the time to understand what the long-term impact of these fees mean to you. (Stay tuned. I’ll have a post soon on this subject soon)
Lastly you may have an option of an index fund. These are usually the lowest cost options which provide reasonable returns over extended periods of time. There is mounting evidence that an index fund may be the best choice for most investors, especially if you want to take a more passive route. Dan Heath & Chip Heath wrote an article in last year’s FastCompany magazine called “Made to Stick: The Myth of Mutual Funds”. They shared:
“Of all 203 mutual funds with at least $100 million under management from 1984 to 1998, only 8 managed to beat the Vanguard 500. Your odds, then, of picking a “winning” mutual fund during that time were less than 4%.”
Why start with a 401K? You start out ahead of the game thanks to your companies contributions. Before actually “investing” a single dime in an index or mutual fund you have already earned a return on your investment.
As you explore the world of investing you will commonly see a disclaimer to the effect of “past performance does not guarantee future results”. With every investment you are taking risk of losing some or all of your money. The best thing you can do before you invest is follow the 1st Principle of Finance.
Once you have begun to contribute to your 401K research the fund options their fee schedule and historical performance. Only after gaining a clear understanding should you begin allocating your money to these funds. In the meantime, investing in an index fund will at the very least ensure that you make as much as the average or lose no more than the average.
Next week I will begin to look under the hood at some 401K options. Sign up for my RSS feed to make sure you don’t miss it!