“I’d like to learn how to invest.” This is something I hear a lot from friends and prospective clients. My Ultimate frisbee teammate asked me the other day what the difference is between a 401(k) and an IRA.
When I was in college, I was jealous of my classmate James who had a portfolio of stocks he would check during class. I didn’t know anything about investing back then (I was a biology major), and although I wanted to, it seemed out of reach. Perhaps you feel that way too.
You’re already an investor, and you don’t even know it
Most of us already have investments through our employer-sponsored 401(k)s. You may have randomly chosen several funds to put your contributions in or sought advice from your smart uncle or co-worker. But regardless, your 401(k) savings are invested in either stocks or bonds. Let me explain.
If Elon Musk wanted to borrow money from you, would you lend to him?
If you lent Elon Musk $10,000 to help him produce a Tesla car, and he promises to pay you back in 5 years plus 4% interest, then you’ve bought a bond. Most bond funds contain bonds issued by the U.S. government and top-notch U.S. companies which will very likely pay their obligations, so this is considered a conservative investment.
If you gave Elon Musk $10,000 in return for being a part-owner of Tesla, then you’ve bought a stock. If Tesla wins big, you win big. But if it goes bankrupt, you lose all your money. It’s high risk/high reward.
You can eliminate the risk of being exposed to just one or a few companies by buying into a stock fund that invests in several hundred companies. There are plenty of stock funds to choose from in your 401(k).
What’s the right combination of stocks and bonds?
It depends on: 1) how long before you need the money, and 2) will you panic and sell all your investments when you see a CNN headline that reads, “DOW DROPS BY 800 POINTS!”
If you’re saving for retirement and it’s about 30 years away, and you believe you can remain steadfast during the next recession and just continue with your monthly contributions, then you probably can invest more aggressively.
If you’re saving for a house down payment 5 years from now, then you probably should invest more conservatively. Stocks can make us a lot of money over long periods of time, but no one knows what it will do over the next few years, since the true value of stocks is masked in the short-term by human emotions—namely fear of losing your money and fear of missing out.
Diversify, diversify, diversify
Question: If you choose 5 U.S. stock funds in your 401(k), are you properly diversified? What about 10 funds?
Answer: If they’re all in U.S. stock funds, then it’s invested in just one type of investment.
We intuitively know we should not put all our eggs in one basket. But true diversification means your 401(k) or IRA portfolio is invested in several different types of investments, which may include international stocks, stocks in developing economies, small company stocks, and emerging market bonds.
If you work with a credentialed investment advisor, s/he can explain in greater detail the differences between investments you can make in your 401(k) and IRA. S/he can help you choose which ones makes sense to invest in, based on the current risk/reward profiles (see below).
*Graph from Research Affiliates. Red dots are stocks. Blue are bonds. Other colors are alternative investments.
In our next blog, we will discuss how to choose from different investment vehicles (Roth IRA, Roth 401(k), Traditional IRA, brokerage account). We will also discuss the impact of fees in your 401(k) and IRA (Hint: It’s in the magnitude of tens of thousands of dollars).