Even though the markets have rebounded since the onset of the recession, conditions remain somewhat unpredictable. That leaves 401k participants wondering what will come next and questioning if their current investment strategy is sound. Charles Schwab & Co. Senior Vice President Mark W. Riepe, CFA, offered six suggestions for 401k participants to consider. Those six tips, plus a bonus tip, are worth following when unpredictable markets are present.
1. Continue Contributing to Your Retirement Accounts.
The idea of a retirement account is that it will provide income when participants reach retirement age. While Social Security may be helpful, current political conditions suggest it will play a smaller part in providing income during retirement years. Mr. Riepe suggests retirees need a backup plan to provide the funds needed to maintain a comfortable lifestyle. That backup is cash from personal savings and investing.
Sticking to a regular 401k savings plan, even through less-than-idea times, is an absolute requirement for building a portfolio sufficient to see participants through retirement. Reipe points out in his suggestions that regularly investing in stocks results in dramatic increases in portfolio value, even when short-term losses are experienced.
Reipe based his statistics on a hypothetical 401k participants saving and investing ten percent of their income. Of course, not everyone is in a situation where that is possible, and the figures will vary according to the actual percentage of income invested. Each 401k investor must evaluate their specific circumstances to determine exactly how much money can be invested, but the central concept of maintaining an investment program remains a constant.
2. Don’t Get Emotional During Market Fluctuations.
Markets will, quite naturally, experience up and down cycles. Just as naturally, investors react to those cycles. When markets are up, investors are enthusiastic about conditions and more willing to commit to additional investments. Conversely, when markets trend downward, depression and self-doubt may interfere with making sound investment decisions.
Good investment strategies require objectivity and balance. Reipe’s second point cautions against simply chasing performance. In other words, past performance is certainly an element to consider, but with today’s rapidly evolving economic environment, looking forward rather than focusing on the past is important for growing a portfolio’s value.
3. Balance the Risks.
Risk is a part of any investment. As a rule, low risk investments generate the lowest rate of return. Higher risks, conversely, tend to garner the highest returns. The question becomes, how much risk is acceptable?
Investment strategists, Reipe included, suggest younger investors are better able to absorb losses than older 401k participants, indicating younger investors can better afford including riskier stocks in their portfolios. Popular thinking says younger investors have more years to recover from a potential loss than older investors.
That does not suggest older investors should ignore quality opportunities with an elevated level of risk. It simply means older investors should have a smaller percentage of higher risk investments in their portfolios. There are always times when taking a risk can be financially rewarding, but protecting the long-term viability of the portfolio as a whole is also important.
Investors must determine how aggressive they can afford to be. While younger 401k participants may wish to see a relatively high percentage of their assets invested in stocks, older investors generally allocate a greater percentage of their assets to bonds and other fixed income investments.
4. Monitor Investments and Make Appropriate Investment Changes Over Time.
The economic environment is not static. It is constantly evolving in response to a number of stimuli. Conditions in national and international markets suggest investment strategies must also evolve to take advantage of current conditions.
Reipe points out that an unattended account changes over time simply due to the performance of the original allocations. What may have been a lower risk allocation when an account was set up may later represent a much higher level of risk. That occurs, for example, when stocks perform at exceptional levels, automatically changing the allocation to represent a higher percentage of investments created by that performance.
The example provided by Reipe is worth keeping in mind. He suggested an investor who allocated 60% of an investment to stocks with the remaining 40% to bonds in 1994 would have, by 1999 seen that allocation shift to 79% stocks and 21% to bonds. That is far riskier than the investor intended. With careful monitoring, the portfolio would not have reached that level of risk.
5. Be Satisfied With Your Investment Choices.
It’s important to be happy with your investment choices. While a particular choice may have seemed appropriate initially, has anything changed? Society changes over time, and there may be investments once deemed acceptable no longer viewed as socially responsible. Not everyone is going to lose sleep over the political correctness of an investment, but others will.
Investors’ personal situations also change. Riepe recommends reevaluating contribution levels on a regular basis to reflect those changes. While it may have been financially prudent to invest eight percent of gross income initially, conditions may now allow a twelve percent contribution. As a career progresses, contribution levels should reflect that progress.
6. Your 401k Should be Sacrosanct.
Of all Riepe’s recommendations, this one is perhaps the most important. Things happen in life that make it tempting to tap a 401k to meet current needs. Not only will dipping into a 401k or other retirement fund generally result in serious tax consequences, it also jeopardizes the long-term success of the account.
A retirement account should be left alone, even when temporary emergencies create economic issues. Growing the account depends on making regular contributions and allowing those contributions to mature without interruption.
Growth depends on time. As Riepe points out, it is an investor’s most important asset, especially during periods of volatility. There is far too much risk for missing an opportunity when markets change virtually overnight if funds are withdrawn for other purposes.
When financial emergencies occur, it makes more sense to borrow money from traditional lenders rather than decimating a retirement account. In addition to lost investment opportunities, withdrawing money early costs far more than paying interest on a traditional loan.
Reipe’s example of withdrawing $20,000 from a retirement account is excellent. Individuals in a 20% tax bracket would pay $4,000 in taxes. In addition, there would be an additional $2,000 in penalties assessed, leaving a total of only $14,000. That is a very expensive way to use money intended for retirement.
Obviously, no one can determine whether or not another individual should withdraw money from a retirement account. However, given the harsh penalties for doing so, it should be an absolute last resort.
7. Your Bonus Tip: Don’t Invest Without Getting Advice.
Because so much is potentially at risk, investing without getting advice is not recommended. Advice, however, can come from a variety of sources. Before committing assets to any 401k funds, careful research is vitally important.
Investment advisors can be invaluable, but relying on the advice of one individual may not result in the best possible returns. When determining asset allocations, advisors can be very helpful, but many are motivated to attract clients to specific funds.
Print materials can also be valuable when exploring different investment options. Most periodicals provide in-depth articles exploring various funds and, typically, include projections for future performance in addition to historical information. The disadvantage of print publications is that many are dated before they are ever distributed. That is especially true during volatile market conditions. Use the information they provide to provide another perspective, but factor in changes since the article was actually written.
Online materials can be very helpful when making investment decisions, but the source of the material must always be considered. If the material is on a website that will profit from readers investing in an investment product, verify any claims by checking other sources prior to committing funds.
What’s Coming Next?
Obviously, anyone who could accurately predict what is coming next would become very wealthy. The reality is, however, that no one truly knows how investment markets will perform in the future. They can only speculate based on historical data and current trends.
That suggests 401k participants must use all the information at their disposal to maximize the growth potential of their portfolios. Since there is no one-size-fits-all investment guide, 401k participants will need to analyze their specific situations and use the findings to establish an investment plan for the future, even when conditions may not be optimal.
Waiting until perfect conditions exist generally means many opportunities have been lost along the way. Volatile, by definition, means changes, both positive and negative, occur rapidly. At this point, market conditions have already improved significantly over those present since 2008. That type of improvement general signals an uptick in other areas of the economy, which is a positive indicator of potential gains in portfolio value.
If a 401k is already in place, now is a good time to evaluate the allocation within the plan and adjust contribution levels. For those contemplating establishing a 401k, the time to start is now. It’s easy to delay, rationalizing the risks are too high, but that argument isn’t supported by historical data. Rather, data suggests the risk to retirement security increases significantly when establishing a savings and investment program is deferred.