The past 50 years have seen incredible advances in investment accessibility for average Americans. With the development of simple indexed mutual funds in the 1970s, average investors gained access to the equity and bond markets that had traditionally only been open to wealthy families and institutions. Further innovations such as ETFs, retirement savings vehicles, and online banking opened the gates even wider. Today, average investors by and large play on a level field with even the wealthiest among us. Yet, because of poor personal finance management, many middle and working class families are missing out on their full retirement potential.
Why is personal finance important?
$24 billion. That’s how much money American workers are leaving on the table every year by not using their employer’s “company match” policy for retirement accounts. The average worker is missing out on $1,336 in free retirement savings every year. Why are we missing out? Ordinary living expenses can easily get in the way of retirement savings, but I think the greater barrier to good investing is the complexity of managing personal finance.
I am an experienced financial professional and I still get confused by all the different savings programs. 401k, IRA, Roth, Traditional, 529 plans, target date funds, fees, match rates, rollovers, etc. This is not a user-friendly system. Fortunately, even though the menu of options is lengthy, savers can follow a few simple guiding principles to make sure their personal finances are in order. Here’s the short version, ranked by importance:
- Invest in things. Saving money is good, leaving it in checking isn’t. We want to put most of our money in some kind of investment that will grow or generate income. Get that match!
- Avoid taxes. There are many ways to invest your savings in a tax-efficient way. It’s easy to get swept up in all the options. Don’t worry too much about optimizing here. Roth versus Traditional is a small difference compared to the difference between an IRA and plain old savings.
- Avoid fees. Fees eat into returns, and this drag on returns can get magnified over time due to compounding. These days there are plenty of cheap options for any investment style. So, there’s no excuse for charging or paying a high investment management fee.
The building blocks of personal finance: 401k plans and IRAs
401k plans and Individual Retirement Arrangements (IRAs) form the base of a good retirement plan. Along with pensions and social security, they represent the bulk of most individual and family savings. Companies set up 401k plans for the benefit of their employees. The employer contributes part of an employee’s paycheck directly into an investment account. The firm managing the account (the “sponsor”) allows the employee to choose a mix of funds from about 20 options. Typical accounts offer stock, bond, money market, and target date funds, as well as employer stock. In many cases, the employer may offer some type of matching program, where the employer contributes additional money to the account.
IRAs are similar to 401k plans except savers manage them independently, without a sponsor. IRA investment accounts can invest in a much wider array of products, but there are certain limitations to how much a saver can contribute per year. For both IRAs and 401k plans, savers can contribute either pre-tax money (Traditional) or after-tax money (Roth). There are pros and cons to each tax treatment but save that for later.
If you are just beginning to invest, you will most likely do all of your investing within tax advantaged accounts like 401k plans and IRAs. This is a big help because in many cases it allows you to skip over analyzing tax advantages and disadvantages of each individual investment (kind of). This lets you focus on the most important aspect of personal finance…
Invest in things
The most important thing to do early in life to prepare for your retirement is to get your savings invested in something, anything. The vast majority of online financial advice gets very nit-picky about what ratios you should invest in stocks and bonds, whether to use mutual funds or ETFs, Roth versus Traditional, and whether to include alternatives like real estate. This is all useful information, but you can safely ignore all of it if you have all of your savings in a checking account.
Just find out about your job’s 401k, or if you don’t have that option, call up your bank and set up an IRA. Pick some different stuff– stocks, bonds, whatever. Try to pick the stuff with simpler sounding names. Mix it up so you have a few different things. Or ten things, whatever. Just get your money into some assets. You can worry about the other stuff later, don’t let those details become a barrier at this point.
Avoid Taxes
Don’t even worry about this part yet! It’s very important but you are already crushing the “avoid taxes” step by using a 401k or IRA. Easy!
Avoid Fees
OK, now back to the stuff we decided to save for later. Now that you have been invested in things for a few months, go back and look at what you have. Each investment fund you picked out should have a prospectus. Skim through the prospectus, looking for information about what fees the fund charges. To oversimplify, we are looking for two things:
- Load charges
- Expense Ratio
Front and back load charges take a chunk of your money when you buy or sell the mutual fund. Fund operating expenses take a chunk of your money each year and are combined and expressed as an expense ratio. We want no loads and low expense ratios. Index funds usually have no loads and expense ratios under 0.2%. In fact some index funds tracking the S&P 500 have expense ratios under 0.1%. Try to re-arrange what you’re invested in to minimize fees. Unless you wound up with a front-end load fund in which case the damage is done already. Don’t sweat it– losses and mistakes happen and you’ll always be learning and improving.
But hopefully you read to the end of this article before following my “invest in things” instructions a few paragraphs ago.
Parting Note
I can’t stress enough how important it is for an early investor to keep it simple. Financial advice is written by financial professionals who have a career interest in figuring out how to turn a 9% return into a 9.2% return. That means they are used to sweating the details. But there are a lot of people out there waiting to get invested until they figure out all the answers about tax deferrals versus tax free growth, etc. You will miss out on growth and income while you are mulling over the details and it’s not worth it. Get invested, then optimize later.
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