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:
- Money market funds
- Stable value accounts (guaranteed investment contracts (GICs) or bank deposit accounts)
- Bond mutual funds
- Stock mutual funds
Kidding. Llamas are not offered as an investment vehicle under any 401(k) plans. If your 401(k) is for some reason offering llamas, consider instead working for a company that is not run by somebody who's insane. Choosing to invest in llamas cannot possibly help your retirement. Now, back to the boring stuff.
Money-market funds and stable value accounts:The types of accounts offer secure ways to make sure that your savings grow at a limited rate. You won't make much off any money put into these vehicles, but you don't stand much chance of losing any either as they consist mainly of certificates of deposit or U.S. Treasury securities.
- Risk: Low
- 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 Rule Your Retirement service, however, does provide asset allocation models, specific investment ideas, and a place for you to discuss your specific situation with a staff of knowledgeable folks.) 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.