Becoming a 401(k) millionaire may be easier than you think. In part 2 of this post, we discuss our three remaining ingredients to become a 401(k) millionaire. We describe what a well tailored long-term investment strategy should accomplish, highlight why 401(k)s are an important tool for savings and review you can catch-up using 401(k)s if you are behind on your savings plan.
3. Invest long-term with a strategy that is fit for you.
It should be as simple as possible, but not simpler in order to incorporate your circumstances and objectives. Unfortunately, many people use strategies based on convenience that may be too simple for their needs. In many cases, these strategies focus only on risk tolerance or age, which may be suitable if you fit some generic profile.
We believe saving and investing are very personal endeavors. A well suited strategy should consider your preferences, financial situation, your goals, the financial returns necessary to achieve your goals or your capacity to ride out uncertainties that inevitably come up. You should be able to understand and be comfortable using the strategy long-term. It is not something that you would discard at the first sign of trouble or when emotions take over. An appropriate strategy should be adaptable to changes in your needs or personal situation. It is not something you should set and forget. Once implemented, monitor the progress toward your goals and make adjustments to the strategy as dictated by changes to your needs and personal circumstances.
A High risk portfolio is not necessary
A high risk portfolio is not necessary to join the million dollar 401(k) club. The risk profile is moderate for the portfolio that generated the 7.2% returns used in this discussion. It is a diversified portfolio with 60% US stocks/40% bonds. A more risky portfolio with expected return of 8.2% would reduce the time it takes for the 22 year old to reach millionaire status by 2 years to 50 years.
Return and risk go hand-in-hand. Even though the time to become a millionaire may be shortened, expect higher highs and lower lows for portfolios with greater expected returns. The trade-off for higher expected returns is the greater likelihood of larger swings in the value of a portfolio. The challenge for most people is for them to stay the course when bad things happen. Were you comfortable with your strategy between 2007 and 2009, when the stock market lost more than half its value? Were you able to ride out the tough period and enjoyed the strong rebound that followed? Or did you get out and missed out as many other investors?
Risk can be managed. Diversification is a great tool that reduces risk but won’t eliminate it. We like to describe a diversified portfolio as one that contains many different holdings and not too much of any one holding. Another way to describe it is “not to put all your eggs in one basket.” Even though the portfolio that generated annual returns of 7.2% for the last 10 years is considered diversified, there were 10-year periods when returns averaged as high 10.5% annually and as low as 1.0%. It was only about 5 years ago in the late 2000s when people lamented the lost decade, when the average annual return on stocks near zero.
4. Save regularly and live within your means
A little discipline goes a long way for financial success. Saving regularly and living within your means today means much more resources for your future. Automatic payroll deductions commonly used for 401(k) contributions help people save automatically. It helps many live within their means because they won’t spend what they don’t see.
The other benefit of saving regularly is that it takes the emotion out of investing. Emotion is often the reason for disappointing results. People buy to chase returns when the market goes up and sell to avoid losses when markets go down. The net result is sub-par returns because they end up buying high and selling low. Studies on individual investor performance confirm that the returns of individual investors are typically lower than professional money managers.
One way to take out the emotions is to maintain an affordable savings program and to invest regularly. Regularity is a natural mechanism for buying more at a lower prices and buying less at higher prices. It mitigates the buy high sell low problem and sets the foundation to participate in market rebounds.
5. Make “catch-up” contributions.
Life can get in the way of the best laid plans to save. Family, school, mortgage and other obligations can throw the best of us off track. Larger contributions can be a safer way to catch-up than taking more investment risk. Someone that did not start contributing until age 35 can still become a millionaire by age 52. They can catch up by making the maximum contribution, use the employer match and 7.2% growth on their investments. The IRS set the 2015 limit to $18,000 for individual contributions. In total, employee and employer(s) contributions cap out at $53,000. The IRS also lets people age 50 or over to make an additional $6,000 contribution, taking the total up from $53,000 to $59,000. Starting nothing in their 401(k) account at age 50, someone can catch-up and reach the $1 million mark in 11 years. One way is to make the maximum $59,000 contribution every year and invest it in a portfolio that gains 7.2% per year.
Reaching the $1 million mark in your 401(k) account may sound difficult at first, but we believe it is very doable with regular savings and investment. Even if a 401(k) is not as your primary way to save, the lessons of starting early to take advantage of compounding and using strategies for savings and investing that is fitted to your needs and preferences are powerful ways to build wealth.