“If everyone is thinking alike, then somebody isn’t thinking.”
–General George S. Patton
“Any fool can make a rule, and any fool will mind it.”
–Henry David Thoreau
The first and only time I had the opportunity to invest in a 401k was when I worked at Capital One. I was a freshly-minted graduate from a top-ten business school, which made me think that I knew everything there was to know about personal finance. Boy, was I wrong? I made two of the four biggest mistakes that you can make with your 401k.
What are those four mistakes?
Read on to find out more.
If you’re like most employees at companies that offer 401k plans, you’re given a short briefing by HR, given some forms, and sent off to do your own thing.
Left without any guidance, you do what most normal people do.
Even if you’ve made these mistakes in the past, it’s not too late to change and get back on the right track.
The Four Biggest Mistakes People Make With Their 401k Plans
Investing the same amount in all of your funds
I remember when I first started at Capital One and was filling out my 401k paperwork. At the time, their 401k offered four funds. I don’t remember exactly what they were, but it was something like an index fund, an aggressive growth fund, an international fund, and a government bond fund.
I knew I needed to diversify and that mutual funds offered diversification.
So, I did what most 401k investors do.
I put 25% of my contribution in each of the funds.
Given that I was 29 years old, and that we generally want to have 110 – our age invested in stocks, I kind of lucked into a reasonable asset allocation.
But, what if there are ten funds? Or what if you’re 50?
You’re probably investing the wrong percentages in the wrong funds.
Investing the default match percentage
If you participate in a 401k plan, then chances are that, if your company offers a match, it’s going to offer it in one of these two manners:
- 100% match of your contributions up to 3%
- 50% match of your contributions up to 6%
Most people assume that because the company match is limited, so are their 401k contributions.
In 2013 and 2014, the maximum amount you can contribute to a 401k plan is $17,500.
Depending on your situation, you may be under contributing to your 401k.
This is particularly true if you want to retire before age 59 ½, because, as we saw in the article “How Do You Bridge the Gap Between Early Retirement and Age 59 ½?”, you can withdraw from your 401k plan without penalty once you reach age 55. You can only withdraw contributions from a Roth IRA, and you can’t withdraw from a traditional IRA without a 10% penalty unless you do 72t distributions or can claim one of the IRS’s exceptions.
What typically happens is that Monkey Brain sees the contribution match percentage and becomes anchored to that number. The next thing that he does is look at your 401k participation form in the spot where it asks how much you want to contribute to your 401k plan. Having just seen either 3% or 6%, he pulls off Monkey Brain see, Monkey Brain do, and enters in that number, not realizing that he can go higher.
Retirement contributions are a great way to hide money from Monkey Brain so that he doesn’t spend it now, because he’d much rather have a man cave and Jimmy Choo shoes than worry about Future You, but if he doesn’t see the money in the first place because it’s been automatically withdrawn from your paycheck, he won’t think about it and won’t tempt you to spend it.
Take advantage of the true 401k contribution limits if you can!
I was fortunate enough to have checked whatever box allowed me to contribute the maximum amount.
So, I was 1 for 2.
Forgetting to Rebalance Every Year
Once we set up our initial investments in our 401k, we tend to forget about them and let them ride. That’s what I did.
This is fine if you’re young and forget about it for a couple of years. You’re not going to do a lot of harm. However, if you forget for 30 years, you’re going to have a problem.
As we saw in the article “Are We Too Conservative in Our Investments When We Are Young?”, the average young 401k plan investor who doesn’t invest in the default fund tends to be underinvested in stocks and the older 401k plan investor tends to be overinvested in stocks.
Because we forget to rebalance each year.
As the Chief Investment Officer of the Yale Endowment Fund, David Swensen, points out in his book Unconventional Success: A Fundamental Approach to Personal Investment (#aff), failure to rebalance costs the average investor .4% per year in returns.
You might not think that amounts to much, but let’s look at a 25 year old who invests $10,000 per year and receives a 7.5% annual return with rebalancing and compare how he does rebalancing to not rebalancing at age 65.
The difference is $276,523.41, just for changing your asset allocation each year. Isn’t that worth filling out a small little form every 365 days?
I didn’t do it. I let my investments ride at the same 1/n investment strategy that I’d employed when I first signed up for my 401k.
Taking out 401k loans
I have three words to describe my position on 401k loans.
I explain my thinking further in the article “4 Reasons to Avoid 401k Loans.”
I never took out a loan, thank goodness.
So, I was 2 for 4.
How about a bonus!
Bonus mistake: Not participating at all!
When you onboard with your company, you probably go through some hour-long mind-numbing presentation about 401ks, investing, blah blah blah.
They gave you a sheet of paper to fill out or told you to go to some online portal to enroll in the 401k program.
You promised yourself that you’d enroll soon.
Soon never came.
If you have an employer match, you are missing out on free money!
In 2008, 28% of employees eligible for a 401k contribution match didn’t contribute enough to get the match. Another 24% didn’t participate at all. That’s more than half of eligible employees who are missing out on free money!
How much do you want to bet that they’ll spend hours cutting coupons or standing in line at the Ben & Jerry’s free cone day?
Please don’t be that person. There’s no excuse for getting a 50% or 100% return on your money, which is what an employer match is. It’s guaranteed. You can’t do better anywhere! Take advantage of it!