For all recent graduates, it really is a lifting of weight from the shoulders when you are hired for you first real job. It is a very exciting event, until adulthood quickly settles itself in. There are student loans to pay back, car payments to make, and a ton of other bills that just seem to keep piling up. All these distractions might shy you away from investing some of your hard-earned money into a retirement savings plan, but it is wise to begin putting away money for retirement as early as possible. There are a few things you should know before jumping right in to a 401K though: How much should you be contributing, what kind of investments to make, how a 401K (most common retirement savings vehicle) works, and what to expect in terms of investment return.
You will need to find out two things from your employer: First: when are you first eligible to begin contributing to your 401K and second: do they offer a matching program. Generally, you will be able to start 3-6 months into your employment. It depends on who you work for, but you may also be able to immediately begin investing, or conversely have to wait one full year to do so. Some companies will also match what you contribute, up to a certain amount. They may match 1:1, 1:2, or not match at all, but if they do offer any kind of matching program, it is just free extra money going into your retirement account.
After you have found this out, you will want to figure out how much money you will be putting away per check. Usually, it works as a percentage of your pay. Depending on your budget, you will want to begin investing between 2-6% of your check to your 401K. One of the main benefits of the 401K is you will not have to worry about taxes until you actually withdrawal the money. Uncle Sam will take his cut when you are ready to retire. This makes the account easy to maintain and additionally allow you to save a little extra money each paycheck since it is being taken out tax-free.
Why invest so early? This will allow you to contribute less each year, and almost guarantee a bigger cash flow when you are in your 60s. This is because of the additional years of compounding interest, and the general rule of stocks being a lot less risky in a long term period. Remember, you will be holding your investments over a 40-50 year period, your investments will be volatile in that time period, but in the long run you will see a substantial gain in your portfolio. For example: we have Steve, who begins investing at age 23, puts away 5 percent of his $40,000 salary, and his company doesn’t offer any kind of matching program. To simplify, we are not taking into account salary raises and we are going to assume a reasonable but conservative rate of return of 8 percent. After 42 years Steve retires at age 65, he will check his account and find $687, 408. Over the time period Steve only vested $84, 000 of his own money. When you factor in salary increases and the possibility of employee matching programs, you can expect a lot more sitting in your 401K. This is why it’s important to start early: We have Dave, who started a little late in investing, but is contributing 10 percent of his $50,000 salary. Using the same assumption of unchanged salary and no matching, Dave starts when he is 35. Even though he is contributing twice as much and has a bigger salary, Dave will only find $472,533 when he is 65, and he has vested $150,000 of his own money! This is the power of compounding interest, and shows the importance of starting as early as possible.
How and What to Invest In:
Depending on what retirement planning company your employer uses, you will have a specific set of investments to choose from. They will mostly be mutual funds, which are multiple investments pooled together with the objective of diversifying the kinds of stocks and bonds you are investing in. You may have about 10 investments to choose, where you assign a percentage of how much money will be invested to each. So if you are investing 5% of your check that is $1000 every two weeks, $50 will be invested into your 401K automatically every two weeks. Of that $50, you decide which percent of it goes where.
Being young and able to absorb a good amount of risk, you will want to put nearly all of it into stocks and be aggressive, so I would avoid investing in any kind of bond investment. A general guideline is to have about 40 percent going into large-cap growth funds, 25 percent small-cap growth funds, 25 percent in large/mid cap value funds, and 10 percent in international funds. Small cap means you are investing in smaller sized public companies (more risky), and Large cap are the big boys like Apple, Coca-Cola, etc. Growth stocks are what young people will want to target, which means the main goal of the investment is to increase it stock price. Since we have plenty of time to let that stock grow, we can take on the risk of this kind of investment. Value funds are less risky, but have lower average returns. The target investment is one that pays out dividends and is undervalued at time of stock purchase. This guideline can be customized to your liking; you can be a little more aggressive or a little more conservative. You do want to pick at least 3 different kinds of funds in order to have a more balanced, diversified portfolio.
You will want to do your research and find out as much as you can about what you are investing in. One important thing to look out for is the expense ratio of the investment, the cost of operating and managing the fund. The higher the ratio, the more they will take out of your gains. Generally, if the account is very active and the manager changes it often, the ratio will be higher. Try and target more rations under 1 to maintain how much you are paying in fees, as they can really add up in the long run.
Sit Back and Watch Your Money Grow! (And occasionally shrink)
Now that you are all set up, there is nothing left to do but forget about your portfolio until you are around 40, where you will want to start thinking about reallocating your investments. The idea is to slowly invest more and more conservatively, so the older you get, the less risk you are taking on. You can expect to make gains just about every year, but there will be times where you might show a loss. Don’t panic, stocks are volatile and go up and down in price all the time. Over a 40 year period, it is almost a guarantee you will have a gain as long as you stick through with your investments and reallocate wisely. I hope this helps out a lot of recent graduates in investing, and I know it can be a bit confusing. If you have any questions please ask in the comments section below and I will do my best to answer!