The other day, I spent some time with a friend who was stressed out about retirement. His employer offered a 401(k) plan, but he had yet to enroll in it. He'd seen friends make money investing in real estate, and he wanted to do that, too. He handed me some paperwork and asked me what he should do. (If you know anyone in the same boat, forward this article to them.)
I've seen many people in similar circumstances. Few of us learn anything about the stock market or investing while we're in school. So we go through life feeling nervous and incompetent, regarding investing. We assume that our friends and neighbors know much more than we do about it -- and we're often wrong about that. (But who would know, since one's finances are a bit of a taboo topic?)
My friend asked some good questions about stocks, and we discussed what stocks actually are. (Many people probably think of stocks as speculative scraps of paper, not as small slices of real companies.) He noted that he doesn't want to lose any money.
Here's some of what I said to him:
If you're not willing to lose some money, you probably won't see your money grow very quickly. There's an important relationship between risk and return. Lottery jackpots offer enormous rewards, but at great risk -- most people reap a reward of zero. Money market funds or government bonds are generally rather safe, but their growth rates are typically not that high. Check out these compound average annual returns between 1925 and 2004, per Ibbotson Associates:
- Small Company Stocks ... 12.7%
- Large Company Stocks ... 10.4%
- Long-Term Government Bonds ... 5.4%
- Treasury Bills ... 3.7%
- Inflation ... 3.0%
Investing over long periods helps. If a stock or the market swoons, it might stay depressed for a year -- or even several years. Short-term investors might find themselves looking at a big loss. More patient investors can ride out the drop, waiting for recovery.
Some stocks won't ever recover. That's why you shouldn't ever put all your money on one or just a few stocks. Just ask people who've kept a big chunk of their nest egg in their employer's stock. Check out these 10-year average annual returns:
American International Group
Although some stocks will disappoint you, many won't -- especially if you spread your money across at least 10 or so stocks, or perhaps across a few mutual funds. Lots of well-known names can serve you well. General Dynamics
Real estate reality
Don't think of real estate as a sure thing, either. Forbes magazine has noted: "From the start of 1980 to the end of 2004, home sale prices increased 247%. A pretty sweet deal, it would seem. Over the same period, however, the S&P 500 shot up more than 1,000%." And real estate doesn't just go up. Houston saw home values drop about 25% over several years in the 1980s.
If you really want to invest in real estate, read up on it, and perhaps even more importantly, talk to lots of people in the area who've invested in real estate, to gather perspectives and advice.
What to do
So what should my friend do? Well, I urged him to take time to learn more before jumping into the stock market. Still, he may want to go ahead and enroll in his 401(k) plan now, because it will result in relatively modest amounts being deposited regularly into his account over time. He won't be plunking his whole net worth into the market in one fell swoop.
Also, he should remember that the market's recent swoon is a good thing for people like him. As I type this, the S&P 500 is down some 13% year to date. Buying now means the market is 13% cheaper than it was on Jan. 1, giving you a better price for America's corporate goodness.
I recommended that he consider starting out by having his 401(k) money invested in an index fund. Then he can study the other options, and perhaps later move some of his contributions into a few other funds. He should contribute at least as much as he needs to in order to earn all matching money from the company.
I commend my friend and anyone else who's starting to plan for retirement. It's a critical thing to do, and too many never get around to it. For detailed guidance, I invite you to test-drive, for free, the Motley Fool's Rule Your Retirement newsletter service. A 30-day guest pass will give you full access to all past issues. The newsletter regularly recommends promising stocks and mutual funds, too.
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