So you’ve decided to start investing in your future, now what? The investing world can be daunting at first, but some basic knowledge can go a long way toward understanding.
Where to Put Your Money
Disclaimer: The information provided here is opinion and does not offer a guarantee on the success of the below investment strategy.
You may have been introduced to investing through your company’s 401K plan. This is a great place to start for a few reasons.
To be successful with investing, you need to make it automatic. You should not have to decide every month how much to invest and in what.
The second benefit of a 401K is automatic diversification. Diversifying your investments is very important and most 401K’s do not allow individual stock picking. Your investment choices mainly consist of mutual funds, which are great for diversification.
Thirdly, about 42% of companies offer a 401K match. Regardless of the match percentage, it is still free money they are giving you just for investing in your future.
Even if your company does not offer a match, the contributions are pre-tax in a traditional 401K. A Roth 401K is an after-tax contribution option, but is usually offered in addition to the pre-tax option.
The benefit to a Roth 401K is that you are not taxed at withdrawal. However, you can only make contributions after-tax. These were created to provide tax relief to retirees. Paying income taxes on your retirement income adds undue stress to a fixed income budget.
If you’re really looking to maximize your savings, then you will need a stand-alone investment account.
There are some great benefits to having a 401K, but there are also restrictions. A 401K was created to assist people with retirement. Therefore, you cannot freely access those funds until you’re 59 1/2.
Also, you are limited to how much you can save every year. When 401K’s were created, pensions still existed and Social Security wasn’t in jeopardy. It was great as a supplement to those things, but not the primary investment mechanism.
Saving money is always important, whether it be for your emergency fund or a vacation fund. You should have a few months of your emergency fund in cash, however the rest should be earning a good rate of return.
Create a stand-alone investment account and begin to contribute on a monthly basis. If you don’t have a cash emergency fund, continue to build that while building your investment savings.
Again, this account should be automatically funded every month. Saving for your future should not be an option and you shouldn’t have to think about it. Even if you can only afford $5, it is never too soon to start.
How Much to Invest
The more money you invest and the earlier you start ultimately determines what you will have at retirement. The decision on what percentage to invest starts with your end goal. Here are some examples.
Assume you start a 401K at age 30 with $0 and earn a 7% return and 5% employer match until the age of 65. You receive an annual raise of 2% throughout your career. If you contribute to your 401K at 5%, you will have $675K when you retire.
With the same set of assumptions, if you contribute 7%, that amount jumps to $855K. To really see a million dollar nest-egg, contribute 10% to retire with $1.1M by age 65.
The benefits of diversification are to ensure your assets do not loose value from market movements. All assets have value and wealth is created when these values increase. Within a group of assets, the more they are unrelated, the better the chance their values won’t all change at the same time.
There are multiple types of diversification, but primarily you can diversify by Asset Class, Company or Industry. Examples of Asset Classes are Stocks, Bonds and Real Estate. Your 401K should ideally be diversified by Asset, Company and Industry.
The best way to accomplish this is through Index Funds. An example of an index is the S&P 500, or the Dow Jones Industrial Average. Index Funds are pools that contain the stocks from every company within that particular index.
You have to ability to invest in a portion of this pool, and you will not be affected much by the movement on 1 or 2 stocks or industries. Diversification by company and industry is satisfied with investments in index funds.
The strategy of diversification by asset class can be accomplished by investing in REIT’s. A REIT is a Real Estate Investment Trust and the fund consists of multiple income generating properties. Whether or not the value of the property increases, the fund receives the benefit of cash flow from tenants.
Now that you have both REITs and Index Funds in your portfolio, you are diversified in types of assets and industries.
Start a 401K at work and contribute as much as you can afford
Open a second investment account
Make your contributions automatic
Establish this diversification strategy in both accounts
Follow these steps and you can live wealthy and retire rich.
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