1. The 401(k)
Here's virtually everything you need to know about a 401(k) plan:
As you can tell, you really can't start too early. The number of years that your investment will be compounding is a huge part of saving for your retirement, but it's not the only part. Making sure that the money is invested properly is also important. And that's exactly the subject behind door Number Two
2. The Stock Answer
If you're young and will be making regular contributions to your 401(k) plan over a number of years, history shows that allocating all of your deferral into stocks will likely produce the highest returns.
[Ed. Note: That's pretty much the main point of Step 2. You can go on to read a bad joke or two and a couple of graphs that show how many hundreds of thousands of dollars might be at stake by putting your money into the right or the wrong allocation over time. Boring stuff like that -- so feel free to head on over to the Living Below Your Means discussion board if you know all this stuff already. Or you can skip to Step 3, which is a good bit, and features a guest appearance by Alex Trebek.]
For anyone new to handling her own finances, the array of investment choices provided by a typical 401(k) plan can be dizzying. Unfamiliar names jump out from the "asset allocation" sign-up sheet, including such obviously frightening concepts as "guaranteed investment contracts (GICs)" and the all-too-familiar sounding "bank deposit accounts." Sometimes there will be 20 or more choices offered, and usually employers offer little help in determining which allocation might be the right one for you.
The chart at the end of Step 1 shows the results that can be achieved if you invest that deferred pay and achieve returns, before tax, of 8% a year on your investments. To do better than that, or at least improve your chances of doing better than that -- it helps to understand the historical performance of the usual choices.
The typical investment choices in a 401(k) plan are likely to be:
Reward: Likewise low, around 4% a year
Bond mutual funds: These are pooled amounts of money invested in bonds. Bonds are IOUs, or debt, issued by companies or by governments. A purchaser of a bond is lending money to the issuer, and will usually collect some regular interest payments until the money is returned. Usually, the amount of interest paid -- the coupon -- is fixed at a set percentage of the amount invested. Thus, bonds are called "fixed-income" investments. Risk: Ranges from very safe (U.S. Treasury securities) to somewhat risky (so-called "high-yield" or "junk" bonds)
Return: From 4%-8% a year Stock or equity mutual funds: Such funds are pooled amounts of money that are invested in stocks. Stocks represent part ownership, or equity, in corporations, and the goal of stock ownership is to see the value of the companies increase over time. Risk: Stocks can and do lose 10-30% of their value in a matter of days. However, if you stick with big U.S. companies, you should be fine over the long term. Return: 10.7% average, with years as bad as -43.59% and as good as +52.83%. There are any number of asset allocation models that propose putting as much as 20% of your money into cash or money market funds, and 25% or more into bond mutual funds. Those who are young and are putting money away for two decades or more should ask themselves whether the decreased volatility of such a model is worth the guarantee that it will not match the historical average annual returns of equities. If you have a 401(k) plan administrator, she won't tell you how to invest your money, even if she knows that, historically speaking, stocks outperform other types of investments. Generally, plan administrators won't expose themselves to any legal liability and won't offer specific investment advice -- markets, after all, don't end up behaving in predictable ways all the time. Or any of the time. We can't offer specific investment advice to you either, because we don't know your specific situation. (Our Foolish 401(k)s discussion board, however, is an excellent place for you to discuss your specific situation with the Foolish community at large.) But if there's a sufficient reason for someone who is decades away from retirement not to take full advantage of the fantastic possibilities that stocks provide, we don't know what it is. All you've got to do to maximize your returns, therefore, is pick the right equity mutual fund. There's a good chance that your 401(k) has the right fund for you. Want to know what it is? Read on. 3. How to Pick a Winner Of all of the questions that have confronted man since the dawn of time, the most oft-repeated and enduring one is probably, "What's for dinner?" A close second is, "Why isn't there anything decent on TV tonight?" Now, a new question increasingly crowds its way into mainstream conversation: "Which mutual fund should I go with?" (On a vaguely related note, you might not have known that the most frequently repeated line in movies is "Let's get out of here." Pay attention the next time you go to the movies -- it'll be in there. You may be wondering whether all of that is strictly relevant at this point. It may or may not be, but you'll have to keep reading to find out.) Tens of thousands… no, hundreds of thousands… no, quite literally, millions of words have been written about mutual funds in recent years in various attempts to answer the question, "Which mutual fund should you go with?" A lot of those words are advertisements, meant to create the impression that some particular fund family or fund manager is the one to be investing your money. There are articles on how to pick the winners. How to get in and out of which funds at which times. There are hundreds of articles on the merits of diversifying your portfolio by holding a number of different funds. We're going to boil down all of the information that you'll ever need to know in as short a form as possible -- but, just to make it more fun, we'll test your linguistic abilities by presenting the answer in the form of a question, Jeopardy-style -- and in different languages. The answer: "Over time, the absolute best performing type of stock mutual funds, bar none." And the question: In Portuguese, "O que sao fundos de deslocamento predeterminado?" In German, "Was sind dynamische Investmentfonde?" In Italian, "Che cosa sono fondi monetari di indice?" In French, "Ce qui sont des fonds indiciels?" In Spanish, "Cuales son fondos de indice?" In pig latin, "Atwhay areway indexway undsfay?" Okay. You really should have been able to figure it out from the pig latin. But if you couldn't, now imagine Alex Trebek is holding a card in his hand and intones, a little disappointedly, "I'm sorry. The answer we were looking for, 'What are…index funds?'" The crowd murmurs with appreciation, as if they knew that fact all along. Actually, most of "the crowd" does know the answer at this point. That stock index funds, especially those that track the Standard and Poor's 500 Index, outperform the vast majority of actively managed equity mutual funds year in and year out is something virtually everyone involved in the mutual fund industry knows -- but it's not something that they'll tell you. Oh. Sorry there. We might have gotten a little ahead of ourselves, because, even though you've now got the answer as to what type of fund to buy, you might, if you're Foolish, be wondering, "Aside from being the best performing funds, what are stock index funds. Tell us more." Glad you asked. Stock index funds seek to match the returns of a specified stock benchmark or index. An index fund simply seeks to match "the market" by buying representative amounts of each stock in the index, rather than hiring a manager to make bets on individual stocks or sectors or investment strategies. Index funds do not even attempt to beat the equities market, they simply seek to come as close as possible to equaling it. Sound simple? Sound like aiming too low? It isn't. The majority actively managed equity mutual funds over time lose to the market averages. Many of the funds that do beat the average market return typically do so for only a very short period of time, and then quickly reverse course. Stocks, as measured by the S&P 500 Index, have historically returned more than 10% per year since 1926. Before moving on, one thing should be made clear. A lot of people think that the most popular index, the S&P 500, is the only index. It isn't. Index funds that match the broader market such as the Wilshire 5000 are also excellent places to be invested. There are even index funds that match the returns of foreign markets, though such funds have not been very good places to be invested of late. Hey, maybe we haven't convinced you that equity index funds are the way to go. But did you know that if you listen to people who make it their careers to know everything about individual mutual funds, you'll potentially cost yourself maybe half (maybe more) of all the money you stand to save in your 401(k)? Sound impossible? The scary story of what happens to those who listen to the experts is but one click away. 4. The Expert's Secrets The following, although Hitchcockian in the terror that it will cause some, nevertheless has to be faced. A typical 401(k) plan might offer five or more different stock mutual funds. The chances that you, dear reader, will pick one or, even less likely, a combination of more than one, that will outpace the performance of a broad-market index fund can perhaps be measured by referring to a June 30, 1998, Wall Street Journal article. That article reports the results of a 1992 challenge that the Journal gave to five very experienced mutual fund "experts." These experts were asked, "Out of all the mutual funds in the whole great big wide world, if you had to pick one to get the highest rate of return over the next 10 years, which would it be? These were the "experts" mind you. These were individuals who make very highly paid careers out of sounding pretty good when they answer this kind of question. These were the Wisest of the Wise. Now, as the Journal noted, the 10 years isn't up yet, but six years ought to tell us a little bit. As it turns out -- it tells us a lot. Tells us everything, some might argue. Out of the five, none picked a fund that outperformed the S&P 500 Index, and two picked funds that were, basically, total disasters. While the S&P 500 returned 196% over the time that was measured, the five experts picked funds that returned between 27% and 192%. The average return of the five was 133%. Of course they never learn either. When asked to pick new funds for the next 10 years, each of the "experts" who hadn't picked an index fund went out and picked a new actively managed fund. We'll come back and check how they're doing, from time to time. To be fair, a few things need to be pointed out. One of the experts did pick an index fund, although he picked a fund which indexed the total stock market of about 6000 stocks, and that fund came very close to matching the S&P 500 return. That index fund was not the very best performing of the experts' picks, either, because one of the funds did outperform it. So it certainly is the case that some (a very, very few) actively managed funds do outperform some index funds over extended periods of time. But even when they do so, it's by very little. It's really just not worth the risk of severe underperformance. The statistical evidence proving that stock index funds outperform between 80% and 90% of actively managed equity funds is so overwhelming that it takes enormously expensive advertising campaigns to obscure the truth from investors. In fact, one of the reasons that actively managed equity funds underperform stock index funds is because they are spending so much money to advertise -- money that otherwise would be invested on behalf of the mutual fund shareholders. Of course, the average domestic managed fund doesn't actually perform nearly as poorly as the ones picked by these experts. The average actively managed domestic equities fund trails the average passive equity index fund by about two percentage points per year, so just picking funds by throwing darts would almost certainly have served you much better than listening to these experts. Even if you're convinced that an S&P 500 index fund is the right one for you, there may still be a problem. What if your 401(k) doesn't offer an index fund? Remarkably enough, according to a 1996 study reported by the Department of Labor, most 401(k) plans don't include an equity index option. If that's true of your plan, then start lobbying your employer to get one, Fool. Rally your fellow employees to the cause by sharing these statistics with them. When a group of you persistently asks for this option, few employers will continue to deny it. It's your money and it's your retirement, so don't be afraid to ask for what you need to build that stash. The old adage about the squeaky wheel is true, so just hang tough and sooner or later your employer will see the light of day. To assist you, we've drafted a letter to your plan administrator that clearly spells out the arguments in favor of indexing. Customize it, print it out, hand it to your employer and keep squawking until there's an index fund made available to you in your 401(k). If your plan does offer an index fund, woo-hoo! You may just decide you don't need to read any further. If you currently have money in actively managed mutual funds while there is an index fund available, consider saying to yourself, as so many movie characters do, "Let's get out of here," and transfer that money to an index fund. If your plan, however, is one of the approximately 58% that doesn't offer an index fund (or if you think that you're really smarter about picking funds than the self-anointed experts) read on. We'll show you how to pick the funds that are closest to an index fund. 5. Index Fund Understanding The line you're in at the toll booth is always the slowest. Somebody else always wins the lottery. The dog has, again, eaten that sandwich you took your eye off for a second. Yup. Life is unfair sometimes. (But what are you doing playing the lottery in the first place? Sure, we sympathize with you about that problem with the toll booths, and I think we've all been there with the dog, but, c'mon, the lottery?) Sorry. Back to the issue we were discussing, which was… What should you do when your 401(k) plan doesn't include an equity index fund? That isn't fair after all, is it? Well, no, it isn't fair, but there is a way out. You need to find a fund that is most like an S&P 500 index fund. Essentially, you are looking for a fund with the following features:
#Prologue. In it, Mr. Bogle writes, "What difference would an index fund make over 50 years? Well, let's postulate a +10% long-term annual return on stocks… If we assume that mutual funds costs continue at their present level of about 2% a year, an average mutual fund would return 8%. This 2% spread is very close to that of the past 15 years, during which the Vanguard 500 Portfolio provided a 2.2% margin of return over the average equity fund (or, more accurately, the better performers that survived the period[.]…[E]xtending this compounding out in time on a $10,000 initial investment, the market (at 10%) would produce $1,170,000 after 50 years; the mutual fund (at 8%) would produce $470,000. The difference in return between the two -- $700,000 -- is an unbelievable 70 times the initial stake of $10,000. "Looked at from a different perspective, our hypothetical fund investor has earned $1,170,000, donated $700,000 to the mutual fund industry, and kept the remainder of $470,000. The financial system has consumed 60% of the return, the fund investor has achieved but 40% of his earnings potential. Yet it was the investor who provided 100% of the initial capital; the industry provided none. Confronted by the issue in this way, would an intelligent investor consider this split to represent a fair shake? Merely to ask the question is to answer it: 'No.'" While I may not be with our fine employer 50 years from now, I do intend to defer more than $10,000 in our 401(k), so I believe that the inclusion of an S&P 500 index fund in our plan would likely make a very significant difference in the retirement that I can look forward to. Given the fact that I understand that I'm looking at perhaps $700,000 or more as a consequence of your reaction to this request, please understand that I intend to be persistent. But only if I have to be. Thank you for your attention to this matter. Very truly yours,
As you can tell, you really can't start too early. The number of years that your investment will be compounding is a huge part of saving for your retirement, but it's not the only part. Making sure that the money is invested properly is also important. And that's exactly the subject behind door Number Two 2. The Stock Answer If you're young and will be making regular contributions to your 401(k) plan over a number of years, history shows that allocating all of your deferral into stocks will likely produce the highest returns. [Ed. Note: That's pretty much the main point of Step 2. You can go on to read a bad joke or two and a couple of graphs that show how many hundreds of thousands of dollars might be at stake by putting your money into the right or the wrong allocation over time. Boring stuff like that -- so feel free to head on over to the Living Below Your Means discussion board if you know all this stuff already. Or you can skip to Step 3, which is a good bit, and features a guest appearance by Alex Trebek.] For anyone new to handling her own finances, the array of investment choices provided by a typical 401(k) plan can be dizzying. Unfamiliar names jump out from the "asset allocation" sign-up sheet, including such obviously frightening concepts as "guaranteed investment contracts (GICs)" and the all-too-familiar sounding "bank deposit accounts." Sometimes there will be 20 or more choices offered, and usually employers offer little help in determining which allocation might be the right one for you. The chart at the end of Step 1 shows the results that can be achieved if you invest that deferred pay and achieve returns, before tax, of 8% a year on your investments. To do better than that, or at least improve your chances of doing better than that -- it helps to understand the historical performance of the usual choices. The typical investment choices in a 401(k) plan are likely to be:
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