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My
Shrinking 401k
by Gary Foreman of The
Dollar Stretcher
Hi
Gary,
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!
Denny
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 fewer 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 Certified Financial Planner who currently
writes about family finance. You'll find more of his columns on The
Dollar Stretcher website.
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