Pearls of Wisdom for 401(k) Investors
Proper investing is crucial to your long-term retirement success. That means accepting volatility but managing risk.
Since 1998, the percentage of Fortune 500 companies offering defined benefit plans has fallen from 45% to just 5%. This places more responsibility in the employee’s hands. Because they do not receive a defined monthly payment in retirement, they rather must save, invest and then make wise withdrawals to live off their retirement savings.
So, it’s crucial for people to understand proper investing for the long term and how to use tools, such as 401(k)s and IRAs.
One of the most memorable quotes I’ve heard from someone who had turned 65 years old and did a poor job saving for retirement was, “I didn’t realize how fast I would get to 65.” This is a reality for many people, and they face this epiphany at various stages in their lives. Some realize the importance of saving for retirement and begin with their first job, while others wait until age 55 and still have hopes to retire at 65.
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While saving for retirement is an important first step, investing properly is crucial to allow your money to compound over time. Managing money for clients, I have seen the problem of people not knowing how to invest their 401(k) monies. They don't have anyone they can turn to for investment advice because the company responsible for the investment portion of the plan generally just wants to collect the fees off contributions. If you're lucky, you'll get sent to an information website.
Get over your fear of volatility
With little investment knowledge, the 401(k) participant is then asked to choose the investments on their own. This leads many to think about their personal risk tolerance. The problem here is many people do not understand the difference between loss of principal and volatility. The stock market can be a volatile investment in the short term, but longer term it can provide great returns. It is important to know that when the market drops, it is not a necessarily bad thing because this means you get to buy more shares at a cheaper price. Who doesn’t love a good sale? If investors do not do silly things by investing in risky companies with high debt and expensive valuations, they will be able to endure volatility without having a serious risk of losing principal.
By associating volatility with risk, many investors are nervous to enter the stock market. This may lead a 30-year-old who believes they are risk averse to have little invested in higher-performing assets and more in safe assets, such as a money market account. While the investor may feel emotionally better about not having to witness the volatility, financially they are destroying their future. As savings sit in a money market account, inflation is eating into them and deteriorating their real net worth.
But don’t go crazy with your money, either
On the other hand, investors who begin saving closer to retirement may feel the need to take more risk to catch up on lost time. This leads the investor to look at risky assets such as small-cap stocks and emerging markets. While there is potential reward there, investors are involving themselves in areas they know little about and that have significant potential downside. Often, we have seen investors go this route in hopes of big returns, only to witness their savings dwindle due to the large risks.
When it comes to investing retirement funds, it is important to educate yourself on what you are actually invested in. You do not have to become the next Warren Buffett, but a general understanding will help appease some of your emotions and hopefully deter you from making poor investment decisions.
- Look for investments that provide a good return, without taking on too much risk.
- Understand that you are investing this money for the long term and that volatility is not a bad thing.
- Realize that even if you are near retirement, you still have a long-term horizon, so it is important to properly invest throughout your retirement years.
For 401(k) investors, I recommend looking for a good value-based investment fund. This means the fund will look at the fundamentals of the companies it owns and look at the valuation ratios for the sales, earnings, book value and cash flow to make sure they are getting a good value. While value does not outperform every single year, over the long term it has produced the best results. Going back to 1927, value stocks have produced an average annual return of 13.5%, far exceeding the performance of the S&P 500, which saw an average annual return of 9.9%.
By properly saving and investing for retirement, investors can get to the years they worked their whole lives for and live comfortably off the nest egg they built.
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