Your 401(k) likely provides you with the best opportunity you have to reach millionaire status by the time you retire. The first step to getting there is to agree to fund your 401(k) -- to contribute from your paycheck into your retirement account. Once you start putting money into the account, how you invest it will make all the difference.
Most 401(k) plans offer a limited range of fund options. That makes your choice one of allocation among available asset classes, rather than the tougher job of picking individual investments among the myriad funds that change hands in the market daily. Which funds are right for you depends on your individual circumstances, but there are a few general guidelines.
7 Key Factors
Your age. The younger you are, the more time you have to recover from a rough market, and the more you should be willing to risk volatility for higher potential rewards. That means that younger investors should generally be able to put more into aggressive options like stock funds. Yes, there will be more and potentially steeper ups and downs with stocks than with many other alternatives, but with time on your side, the higher potential returns make it likely worth those higher risks.
Your invested net worth. When all is said and done, investing for retirement is about coming up with enough money to cover your costs for the rest of your life. The more you have socked away already, the lower your required future returns are to reach that target, and the less aggressive you can afford to be. As a result, the higher your invested net worth, the more of your money you can afford to put into lower-volatility options like bond funds and still meet your goals.
Your risk tolerance. Any investing strategy that you take needs to be compatible with your personality and willingness to accept risk. The reality is that investing with mediocre returns beats not investing at all. If rough patches in the market would scare you out of investing entirely, you'll likely wind up better off investing in lower-volatility strategies like bond funds than avoiding any investing at all.
Expected inflation. Your retirement funds need to last you the rest of your life, and a 30-year retirement isn't uncommon anymore. Even at a fairly modest 3 percent inflation rate, it'll take about $2.43 to buy the same amount of goods and services 30 years from now that $1 buys today. On top of that, health care costs -- which generally rise with age even before considering inflation -- have been rising faster than general inflation for many years. Because of inflation, you'll need to keep some exposure to higher-volatility/higher-potential-return investments like stock funds that have the potential to provide real growth, even while you're retired.
Your expected retirement length. The longer your retirement, the larger a nest egg you'll need to see you through it. If you have a family history of longevity, are in great health and want to retire young, you'll need more than someone who subscribes to the belief that the sooner you retire, the earlier you pass away. As a result, if you expect a long retirement, you'll need to be more aggressively invested -- tilted more toward stock funds -- than if you expect not to have much time after you're done working.
Your other sources of retirement income. Social Security provides an inflation-adjusted income stream to everyone who qualifies for it. Many traditional pensions are not inflation-adjusted. As a result, even if you do have a pension, you will likely have to put some consideration toward fighting inflation. That said, the more of your needs that are covered by other income sources like a pension and Social Security, the less aggressive you'll need to be with your investments, and the more you can put toward bond funds.
Your anticipated retirement lifestyle. The more expensive your lifestyle in retirement, the more you'll need in your nest egg to cover it. If you're content rocking on the porch and watching the world go by, you can get away with a more conservative asset allocation -- and lower stock fund exposure -- than if you'd like to spend your golden years exploring the world.
Implement a Plan That Works for You
Choosing how to invest your 401(k) is as important as making the choice to invest in the first place. By using these seven key factors as guides, you can design and execute an investment allocation that works for you. Once you've made your initial choice, remember to revisit it from time to time. As life happens, time passes and your plans change, what may have made sense to you in the past may no longer fit your current vision of your future.
Even then, when your future self is adjusting the plans you make today, you'll likely realize that the act of investing in your 401(k) was one of the best financial decisions you've made. So get started now, and enjoy the long-term benefits that come from a career of investing smarter in your 401(k).
Chuck Saletta is a Motley Fool contributor. Try any of our Foolish newsletter services free for 30 days.Motley Fool retirement experts have created a free report on a simple strategy totake advantage of a little-known IRS rule to boost your retirement income.