My Shrinking 401k
by Gary Foreman
This is my second year contributing to a 401k plan. For the last six months my statements show that I have lost a lot of money. I invest 50% into a growth fund. I am young and I want to take some risk, but now I'm concerned. I don't know if it is smart to keep investing in those excessive growth funds while the stock market is not doing so well. Some people advise that I should still contribute every paycheck. They say that I get to invest at a time where stock prices are low. Please help!
Good question! And one that a lot of people are asking now. After a decade of rising stock prices many people have discovered that stocks can also decrease in value. So what's the best strategy now? Is it wise to keep putting money into a 401k plan?
Let's begin by considering 401k plans. No matter what happens to the market in the short term, a 401k plan is a great way to save for retirement. The reasons are simple: tax advantages and dollar cost averaging.
The money that you put into a 401k plan is not included in your taxable wages. So you pay less taxes on your income this year. Plus, no taxes are due on any interest or growth within the 401k until you take the money out of the account. That means that the money will grow much faster than it would in a taxable environment. Assuming that he's 30 now, that could mean a retirement account that's between two and four times larger than one that was taxed each year. So continuing to contribute to the 401k plan is a good idea.
But what about the stock market? Denny's losing money now. Is there any guarantee that will change? Well, there's no absolute guarantee. But 200 years of history show that if he stays in the stock market for a 10 year period he'll earn about 10% per year. Some years will be better and some worse. But the average has been remarkably stable.
Which leads us to the second reason why a 401k plan is great for retirement. Denny's friends have already pointed it out. A 401k forces Denny to take advantage of "dollar cost averaging". That's where you invest the same dollar amount regularly. In Denny's case he's investing about the same amount every pay period. When stock prices drop his 401k contribution purchases more shares.
Whenever the market does turn around he'll own a larger number of shares. That means a bigger increase in his account. We don't have space to describe the math, but if you regularly invest the same dollar amount in a specific stock or fund, you actually do better if the price doesn't continually increase. It's better if it dips occasionally.
Should Denny jump out of the market now and get back in when it's ready to go up? No! It's almost impossible to predict the stock market. He'll make more money by just using a 'buy and hold' strategy. If he tries to time the market it's pretty sure that he'll make mistakes that will cost him dearly.
Next let's look at where the money is invested. Denny mentioned that he was in a 'growth fund'. He needs to recognize that growth funds are more volatile than other funds. They depend on the companies continuing to grow at an above average rate. And if that doesn't happen stock prices can drop quickly. So he might be better selecting a more balanced fund.
Some experts would advise Denny not to try to pick a fund that will do better than the market. John Boggle, founder of the Vanguard mutual funds, suggests that most investors would benefit if they just selected an index fund. Those are the funds that track a specific market or index. Managers don't try to pick winning stocks. They just mirror a market or index. The advantage is that these funds have lower expense ratios which helps boost return.
Denny may not have the option of selecting an index fund. In that case he'll need to compare the fund goals, performance and management of the available choices. One thing that Denny needs to recognize is that time is on his side. He doesn't need a big return every year to build a nice retirement nest egg. Suppose he gets the 10% historical return on stocks. If he's 30 now, every dollar that he puts into the 401k will be worth $32 when he's 65. No wizardry is required to save a sizeable amount.
Right now Denny should check to make sure that he's selected the right mutual funds. Once he's made that selection he shouldn't worry about the market. He needs to remember that a 401k plan is a long range investment. Just as you wouldn't judge a marathon runner over the first 100 yards, it's not wise to judge your 401k plan on one or two quarters. In this case, the race goes to the steady saver who continues to invest in both good and bad markets.
Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money and CreditCards.com. Gary shares his philosophy of money here. You can follow Gary on Twitter or visit Gary Foreman on Google+. Gary is also available for audio, video or print interviews. For more info see his media page.
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