Sunday, October 20, 2013

Deciding Where to Invest Your 401K

Invest wisely and enjoy an early retirement
When you kick off your career, the most important first step to securing your financial future is to start investing.  When you’re young, you have one of the most valuable assets on your side, which is time.  Time allows you to benefit from compounding growth, where you start seeing growth upon the growth.  In most cases, your employer will even match up to a certain percentage.  It’s a no brainer and you might as well take the free money.

Why should I invest?
To convince you that investing is important, from 1950 through the end of 2009, which by the way includes the great recession, the average return for the S&P 500 was 11.0% a year.  The S&P 500 is a good representation of how the overall US stock market performs.  Although each individual year may have large positive and negative swings, the overall direction is up.  If you invested $1 in 1950, you would have over $520 at the end of 2009.

So many choices
Once you decide to invest, which you should absolutely do, you’ll be confronted with a wide variety of investment options.  Life is always full of choices and investing is no different.  At my company, the 401K plan contains a whopping 22 different investment options.  Compared to all the possible stocks and funds out there, this is a lot less, but you still have some choices to make.  Don’t worry, it’s much easier than you think!

You’ll typically find several funds with different target retirement years.  If you’re just starting out, you’ll choose a retirement year that is farther out.  When you’re still far away from the target retirement year, the fund will invest more aggressively, while once you start nearing the target retirement date, the fund will shift to a more conservative investment strategy, usually involving more bond investments.  Next, you’ll find several different funds with all different strategies, some investing in specific types of companies, others investing internationally, etc.  Lastly, you’ll probably also have the option to invest in your company stock.

You’ll be confronted with lots of information about how the funds have performed in the past, and while you may be tempted to go with a winner from the past, chances are that the fund will not continue it’s winning streak into the future.  Most funds and investments are unable to beat the market year after year.  In fact, most companies can’t continue beating the market year after year.  In one year, you might do very well with an individual stock, but knowing which individual stock will do well year after year is near impossible.  If investment professionals can’t do it, what makes you think you can do it?

Invest in index funds
Well then, if most investment professionals can’t beat the market, what should you do?  Invest in the overall market and do as well as the market does.  While this strategy isn’t as exciting or as sexy as other options, you’ll end up beating out most other investors.  It seems so simple, but it works amazingly well.  Index funds track the overall performance of various markets.  For example, the Fidelity fund FUSVX or the Vangaurd VIIIX track the overall performance of the S&P 500.  Other funds such as FSEVX or VSGIX track the performance of the broader market and smaller companies (companies outside of the S&P 500).  An added benefit is that since they’re just tracking the market, the fees are minimal.  For the VIIIX, the annual fee is 0.02% a year, or roughly $0.20 per $1,000.  Compare this to a fund like the Fidelity Contrafund, which is a professional managed fund and charges 0.57% a year, or roughly $5.70 per $1,000 invested.  The fee is over 28 times higher but you’re not getting 28 times the performance.  In fact, the more expensive fund is probably performing about the same if not a little worse.  I’ll take the fund that charges me 0.02% a year for performance that is just as good and usually better than a professionally managed fund.

By investing in an index fund that tracks the general market, you can rest assured that you’ll do as well as the US economy performs and you’ll wind up beating most other investment strategies.

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