As with so many things in life, the responsibility for maximizing the potential benefits of your 401(k) plan falls largely on your shoulders. In this article, we'll give you six tips to make a healthy and growing 401(k) a reality.
If your employer offers a 401(k) plan, you should participate in the plan. The math is simple: if you don't put anything into it, you won't get anything out of it. Once you've made up your mind to get started, don't procrastinate. When it comes to 401(k) plans, time is your friend. The sooner you start contributing to the plan, the longer the span of time your money has to grow. If you delay participating, time works against you. To make up for lost time, your contribution rate will need to be higher and/or your rate of return greater to achieve the same retirement nest egg that could have been built with fewer dollars and lower rates of return had you started earlier.
2) Take the Company Match
One of the first questions that most 401(k) plan participants ask themselves is, "What percentage of my salary should I contribute?" This is an easy question to answer. Invest as much as you can afford, but no less than the amount required, to receive the full company match. The company match is free money. Think of it as an instant return on your investment, and don't let even one penny go to waste. (For further reading see Making Salary Deferral Contributions Part 1 and Part 2.)
Proper asset allocation is responsible for the majority of investment returns. It is a time-tested principle that offers a valuable lesson for investors. So, learn from this lesson and plan your portfolio accordingly. If you start investing when you are young, take an aggressive approach and choose stocks over bonds. While it is true that stocks present a greater risk of loss than bonds, the potential rewards are also greater.
Once your portfolio is in place, monitor its performance. Keep in mind that various sectors of the stock market do not always move in lockstep. For example, if your portfolio contains both large-cap and small-cap stocks, it is very likely that the small-cap portion of the portfolio will grow more quickly than the large-cap portion. If this occurs, it may be time to rebalance your portfolio by selling some of your small-cap holdings and reinvesting the proceeds in large-cap stocks. While it may seem counterintuitive to sell the best performing asset in your portfolio and replace it with an asset that has not performed as well, keep in mind that your goal is to maintain your chosen asset allocation. When one portion of your portfolio grows more rapidly than another, your asset allocation is skewed in favor of the best performing asset. If nothing about your financial goals has changed, rebalancing to maintain your desired asset allocation is a sound investment strategy. (To learn more, see Achieving Optimal Asset Allocation and A Guide To Portfolio Construction.)
The concept of diversification basically comes down to the old adage, "Don't put all of your eggs in one basket." If we update that saying for modern investors, it might go something like this, "Don't put all of your eggs in one basket - especially if that basket is your own company's stock or last year's 'hot' mutual fund." Spreading your assets among a variety of investments reduces risk. Risk reduction is particularly important when you consider that a 50% loss in a given investment requires a 100% return on the remaining assets just to get back to break-even status in your account. (For further reading, see The Importance Of Diversification.)
5) Avoid Loans
In an ideal world, responsible 401(k) plans wouldn't even offer loans. Unfortunately, the truth about 401(k) plans is that contributions by a company's CEOs are limited by the workers' contributions, so as long as the workers contribute (even if they take it all back out) the company is happy. As a savvy investor, you need to remember that a 401(k) plan isn't a piggy bank, and that every dollar you borrow is a dollar that is now working against you. Some borrowers argue that paying yourself back with interest is a good way to build your portfolio, but a far better strategy is to put your money in the plan and let it go to work. This is your long-term savings vehicle. Your future depends on its success, and borrowing money interrupts progress. (See Borrowing From Your Plan.)
6) Take It with You When You Change Jobs
Most people will change jobs more than half-a-dozen times over the course of a lifetime. Far too many of them will cash out of their 401(k) plans every time they move. This is a bad strategy. If you cash out every time, you will have nothing left when you need it. Even if your balance is too low to keep in the plan, you can roll that money over to an IRA and let it keep growing. (See Moving Plan Assets: How To Avoid Mistakes.)
The formula for increasing your odds of a happy retirement is easy to understand and easy to follow. It begins with participation in the plan, which includes the implementation of a sound asset allocation strategy. Next, you need to monitor your investments and rebalance periodically. To cap off your efforts, use the tried and true strategy of "buy and hold" so that, once your money is in the plan, it stays there and compounds over time into a sizeable retirement nest egg.