401k Strategy - Common Mistakes You Can Easily Avoid.
This article will help you create your own 401k strategy by first identifying common mistakes others have made.
The first most common mistake is failing to contribute a sufficient amount to your plan. Know that this step alone is the most powerful driver in your achieving a successful retirement outcome, which is not outliving your money. How is saving so powerful? If you are stuck because you are focused on investment returns and the risk necessary to achieve those returns, consider a 100% return on $1,000 vs. a 5% return on $200,000.
The next common mistake is submitting to your 401k plan's default investment option: theTarget Date Fund. How is this a mistake? Well, the product design begins with a theory that as you get older you need less exposure to the risk of the equity markets and more exposure to the safety of bonds. Yet, there is a serious disconnect between the theory and application. The only way for the product to give you exposure to bonds is to allocate your money to bond funds. The one thing about bond funds that I never hear mentioned is interest rate risk. Bond values and bond fund values move in the opposite direction of interest rates: if interest rates go up, bond and bond fund values go down. If interest rates go down, bond and bond fund values go up.
Basically, bond funds fail to provide the one characteristic that makes them the "safe" investment: a maturity date. The reason wealthy people buy bonds is that they expect to get all their money back on the stated maturity date. This characteristic allows them to ignore interest rate risk because their intent is to hold the bonds until maturity. Without a maturity date, values will fluctuate and there is not even a promise that all your money will ever be returned to you.
Bond buyers employ other strategies to offset risks such as Reinvestment Risk which is the risk that when the bond matures the interest rate paid on similar bonds will be lower than what the original bond paid. Other risks are Call Risk, Default Risk and Inflation Risk. None of these issues apply to your 401k because it is unlikely you can directly purchase bonds in the account.
The next most common mistake plan participants make is what is known as an error in Portfolio Construction. This is simply having too much invested in a single product. Some plan participants are so fearful of making a mistake they fail to make any decision. Prior to the more common default option of the Target Date Fund, the default was money market. Know that there is no way your account will grow sufficiently to provide for your retirement if it is parked in a money market account. It does not matter how much you save, inflation alone will eat up your purchasing power and you will not make it through retirement ~ you will outlive your money.
There are those who recognize this and opt for the "Stable Value Fund" which is only a small step beyond the money market account. Again, the risk of all your money in this account is that it will simply not provide the growth necessary to create an asset base that will outlast your expected lifetime in retirement.
Portfolio construction errors also occur at the other extreme. Some plan participants choose to put all their money in the highest risk asset class available in their plan. They seem to be attracted to the historical high returns despite the wild volatility. They think that they will be alright because they are young and can recover from any unrealized losses. I call this a form of "magical thinking" most often associated with youth. The real secret to successful investing is to avoid catastrophic losses. The returns necessary to recover from such losses only opens the investor to greater and greater risks. It is like chasing your losses in a poker game without holding a winning hand.
These are the most common mistakes plan participants can easily avoid. These mistakes are primarily because they do not have a 401k strategy. If you use the tools provided by your employer and use their recommended asset allocation strategies you will be on the right track ~ provided you view the asset allocation as a beginning rather than the final answer. There are other tools outside those provided by your employer. Invest in your own financial education. Begin with a study of tactical asset allocation.
The first most common mistake is failing to contribute a sufficient amount to your plan. Know that this step alone is the most powerful driver in your achieving a successful retirement outcome, which is not outliving your money. How is saving so powerful? If you are stuck because you are focused on investment returns and the risk necessary to achieve those returns, consider a 100% return on $1,000 vs. a 5% return on $200,000.
The next common mistake is submitting to your 401k plan's default investment option: theTarget Date Fund. How is this a mistake? Well, the product design begins with a theory that as you get older you need less exposure to the risk of the equity markets and more exposure to the safety of bonds. Yet, there is a serious disconnect between the theory and application. The only way for the product to give you exposure to bonds is to allocate your money to bond funds. The one thing about bond funds that I never hear mentioned is interest rate risk. Bond values and bond fund values move in the opposite direction of interest rates: if interest rates go up, bond and bond fund values go down. If interest rates go down, bond and bond fund values go up.
Basically, bond funds fail to provide the one characteristic that makes them the "safe" investment: a maturity date. The reason wealthy people buy bonds is that they expect to get all their money back on the stated maturity date. This characteristic allows them to ignore interest rate risk because their intent is to hold the bonds until maturity. Without a maturity date, values will fluctuate and there is not even a promise that all your money will ever be returned to you.
Bond buyers employ other strategies to offset risks such as Reinvestment Risk which is the risk that when the bond matures the interest rate paid on similar bonds will be lower than what the original bond paid. Other risks are Call Risk, Default Risk and Inflation Risk. None of these issues apply to your 401k because it is unlikely you can directly purchase bonds in the account.
The next most common mistake plan participants make is what is known as an error in Portfolio Construction. This is simply having too much invested in a single product. Some plan participants are so fearful of making a mistake they fail to make any decision. Prior to the more common default option of the Target Date Fund, the default was money market. Know that there is no way your account will grow sufficiently to provide for your retirement if it is parked in a money market account. It does not matter how much you save, inflation alone will eat up your purchasing power and you will not make it through retirement ~ you will outlive your money.
There are those who recognize this and opt for the "Stable Value Fund" which is only a small step beyond the money market account. Again, the risk of all your money in this account is that it will simply not provide the growth necessary to create an asset base that will outlast your expected lifetime in retirement.
Portfolio construction errors also occur at the other extreme. Some plan participants choose to put all their money in the highest risk asset class available in their plan. They seem to be attracted to the historical high returns despite the wild volatility. They think that they will be alright because they are young and can recover from any unrealized losses. I call this a form of "magical thinking" most often associated with youth. The real secret to successful investing is to avoid catastrophic losses. The returns necessary to recover from such losses only opens the investor to greater and greater risks. It is like chasing your losses in a poker game without holding a winning hand.
These are the most common mistakes plan participants can easily avoid. These mistakes are primarily because they do not have a 401k strategy. If you use the tools provided by your employer and use their recommended asset allocation strategies you will be on the right track ~ provided you view the asset allocation as a beginning rather than the final answer. There are other tools outside those provided by your employer. Invest in your own financial education. Begin with a study of tactical asset allocation.