This blog post is for people who do most of their putting aside of money for retirement in their 401ks. Other people can use it just as well, though.
Most people have 401ks and it is strongly advised by anyone who knows anything about personal finance that the first thing anyone should do when saving for retirement is to put money into their 401k equal to whatever their company is matching.
Most people suggest that should be in a regular 401k, where you pay into it before taxes now and whenever you withdraw it you pay taxes then.
The math on choosing a regular 401k for this is rather shaky and assumes such things as being in a lower tax bracket later than you are now which further assumes that tax rates aren’t likely to go up substantially in the next 30 or 40 years. I don’t intend to talk much about those shaky assumptions here, just to note that they are present.
As far as what I think, I would say diversify it. Have a pre-tax 401k at work and a Roth IRA at home and contribute to both. That allows you to buffer against risk of changes to tax laws and other things.
For the purposes of this post, it doesn’t matter which you choose.
When somebody sets up their retirement accounts, they need to decide how to divide up their contributions to those accounts. Somebody might choose to invest part of their money into a diversified stock index and a diversified bond index, for example.
The most important thing to understand at this point is how much risk you are willing to take. Generally, people tend to be more willing to take risk early on when they are trying to chase the highest returns and people tend to be less willing to take risk later on when they are trying to keep their account value from decreasing just prior to retirement.
A lot of sources commonly give advice of putting your age percent into bonds and putting the rest into stocks. For me at 35, that would give me 35% bonds and 65% stocks. I will assume for the purposes of this article that this is a good idea. Fifteen years from now, as the advice goes, I should drift more towards a 50/50 split.
I could potentially have multiple different stock funds and multiple different bond funds here if I wanted to, as long as the percentages held up.
There are also some funds out there where a single fund has such a mix built into it by the people that invest the money. That would also work.
Target Retirement Date funds also do a similar thing, but I generally don’t like those because they tend to have higher fees than other options that are usually available.
Note, it’s really important when you are doing this that you come up with an asset allocation that you are personally comfortable with maintaining. The worst thing you can do is to experience losses and then change your strategy.
You must be willing to continue with whatever your strategy is before you start on your strategy. If you are unwilling to experience large losses in your account value, you probably want to lean harder towards bonds, because their values tend to be more stable over time.
If you can only stomach having 40% stocks and 60% bonds and that’s all you are willing to stick out, then invest like that the entire time. Don’t go 80% stocks and then experience losses and then due to fear decide to change up. You will cripple your long term results if you do this, I promise.
Once you have chosen how you want to divide up your assets, then stick with that. If your strategy involves slowly altering your allocation over time, that’s good too, just stick with it. Don’t abandon your strategy because of fear.
If only it was just as simple as that.
See the market likes to reward investments at different rates. You might have faithfully contributed to an account at a split of 50% stocks and 50% bonds and investment performance might leave you one day with 60% stocks and 40% bonds. Ideally, in times like these you want to try to get closer back to your original allocation.
There are two primary ways of doing this:
- Immediate one shot rebalance
This means you go into your account and sell some of the portion that is too high and buy more of whatever is too low. It’s relatively common for people to do this, but it should be noted that it involves a lot of potentially costly transactions.
- Rebalance using new contributions
This means changing how your future contributions are divided up. If you were doing this and you wanted 50/50 but ended up with 60/40, you might just direct all future contributions to buy 100% of the 40 until the account was back to 50/50. At that point, you might return to having your contributions be 50/50 again. It would also be ok to go 10/90 or 20/80 and get to the end result more slowly if you still want new contributions to go some into each.
Which is better?
I personally lean more towards the latter. A lot of people prefer the former, though, and the former has definitely been shown to work rather well. Both types logically should do pretty well. Either way, you should be able to get where you are going and either way you should end up where you want to be.