Step 1 - Understand That A 401(k) Is For Retirement Investing
A 401(k) is essentially a way to save for retirement. Therefore, there are penalties if you use the money for something other than your retirement. Of course, retirement is perhaps the most important savings goal you'll have, so you shouldn't be reluctant to save for it, but do plan for the money you put in a 401(k) to be accessed only once you've retired - it is not meant to be a slush fund to buy a new car in 5 years.
Step 2 - Don't Delay Contributing To A 401(k)
It's important to not let fear delay you from beginning to save with a 401(k). One of the most powerful methods of investing is starting early with a diverse portfolio. To illustrate, if you earn a return of 6% per year - realistic based on historical performance - then your money will double every 12 years. If you start investing 36 years before you retire, then that initial dollar you invest has the potential to double three times - that's an eightfold return due to the power of compounding. In short, if you start investing early, the returns can be impressive.
Step 3 - Maximize Your Employer Match If You Can
With a 401(k), investing becomes even more appealing, due to your employer match. If your employer is willing to match your contributions to a certain level - and many do - then the match can jumpstart your savings. A 401(k) can be one of the most powerful ways to grow your savings. If your employer offers 100% matching up to 7% of your salary, for example, then you can essentially double your savings right off the bat. So, if you can afford to, then investing in your 401(k) up to the employer match can be one of your best saving options. It also has the side-benefit that your savings will grow in line with any future salary increases. Investing above the employer match is up to you, and at that point you may find that at an IRA offers a broader selection of lower cost investment options.
Step 4 - Hold A Majority of Your Assets In Stocks For Long-Term Investing
Generally, investing in stocks can offer very attractive risk/return characteristics based on history, if you're investing over decades. You can see a more precise suitable allocation for your age and risk tolerance on our dashboard. However, generally speaking, subtracting your current age from 110 can give a reasonable approximation of what proportion of your portfolio should be held in stocks. It may be a bumpy ride at times, as the market can fall sharply and unexpectedly, but over time you'll generally end up significantly ahead of other asset classes if history is any guide. For example, stocks have tended to double about every 12 years, based on average US stock returns. However, stocks can suffer abrupt ups and downs, so it's important to be confident that you are truly investing for decades. Otherwise, stocks may carry too much risk for your situation. If you're investing in a 401(k), then you're investing for retirement, so if you're under 45, you likely won't need the money for at least 20 years. In this case, stocks are a good option for you.
Step 5 - Build A Diverse Portfolio
In addition to holding stocks, consider diversification via exposure to bonds, Treasury Inflation-Protected Securities (TIPS), and real estate investment trusts (REITs). Also consider international diversification as a way to smooth returns. You can set up a free account at FutureAdvisor to browse recommendations for your age and risk tolerance, based on the principles of Modern Portfolio Theory.
Step 6 - Pay Attention to Fees
Fees can eat into your savings over time; look for low-cost options where available. Ideally you want to pay under 0.60% in fees, and often fees can go as low as 0.05%. However, your 401(k) may have limited low-fee options; in this case, invest up to the value of the employer contribution match and use an IRA to make up the balance of your saving, as you'll have better investment options here.
Step 7 - Look For Opportunities To Increase Your Saving Over Time
Ideally, a good 401(k) can be set up and, aside from the occasional rebalance, essentially left to put your money to work for you over time. However, if you get a pay raise or a bonus, see if your finances allow you to increase your salary percentage 401(k) contribution, because saving money you are not yet accustomed to spending can be easier than attempting to change spending behavior later.