Section III-A - Lesson 4
Your 401k - Selecting The One Best Investment
Once you've established a contribution to your account, you're asked to decide how you want to invest this money. You're typically presented with a list of a dozen or more potential investments of various sorts and invited to select one or more of them and allocate your contribution accordingly.
There will always be one, and only one, best selection for you on the entire list of investments, and this will be the most widely diversified domestic common stock fund on the menu, ideally an S&P 500 Index fund.
Trust me when I tell you that none of the other investments listed on your menu are appropriate for your long term needs. Not the money market funds, cash reserves and guaranteed investment contracts (GIC's). Not the bond funds, and not the balanced funds or the so-called life-cycle funds. And not the stock funds that are specialized in nature instead of being broadly diversified.
If your company offers shares of it's own stock as an investment selection for your 401k, do not allow yourself to be coerced into choosing it. It matters not whether you work for a large, established firm like Exxon-Mobil, an exciting newcomer like Dell, or a little dot com start up firm. Company stock does not belong in a 401k! Period! If you don't believe me, ask anyone who used to work for Enron (once the 7th largest corporation in America and now defunct.)
To really get a rundown on the various kinds of investments you're likely to see on the menu of your own company's 401k plan, you owe it to yourself to check out the extensive information in our book, Financial Independence 101 (now available for immediate download in PDF format at only $9.95).
It's often made to sound like the more investments you pick, the better, and this unfortunately appeals to some innate fear that many of us have about "not putting all our eggs in one basket". The participant is made to feel that he or she is somehow "safer" and wiser for splitting the investment between a number of selections.
The fact of the matter is that splitting your investment will only make you poorer! When you select the most widely diversified domestic common stock fund on the menu you will be setting yourself up to get the highest possible rate of return on your money over the longer term.
Most mutual fund companies that service company 401k plans offer something akin to an S&P 500 Index fund. Both Fidelity (see Your 401k Fidelity Investments Account) and Vanguard (see Your 401k Vanguard Funds Account) offer such a fund, and these are the two major players in the mutual fund business.
When you purchase shares of an S&P 500 Index fund you are participating in the growth of the 500 largest and most influential companies in America that jointly represent more than 70% of the value of all U.S. traded common stocks.
You are essentially "buying the general market" and over the years you can expect to get the rate of return of the general market, which since 1926 has been more than 10% annually.
This Index fund provides a simple, easy solution to the challenge of selecting the right investment. With this fund you will always be widely diversified in a broad based cross section of the American economy and you should expect to prosper over the years as our country prospers.
You should "allocate" 100% of your contribution to this investment. Anything you split it with will greatly reduce your long-term overall rate of return and will not gain you any further meaningful diversification. Your money is already "split" amongst the 500 most prestigious corporations in America, so you certainly don't have "all your eggs in one basket".
What about stability, you might ask. Couldn't you expect less fluctuation in the value of your holdings if you balanced your stock fund holdings with a bond fund or money market fund, for example?
Sure you could, if you were willing to give up half, or two-thirds of your potential wealth for the sake of not seeing your investment fluctuate from time to time. I hope you're not willing to do that. If you're the least bit unclear about this, go back and re-read the lessons about understanding risk in the previous section.
Take time to realize, on an emotional level, that your 401k is a long-term investment proposition and that, because you won't be needing most of the money for many years to come, you don't really need to be concerned about the fluctuation, but only about the long-term rate of return.
In a long-term investment program - spanning 30 years or more - time, diversification, and the timing technique of dollar-cost-averaging (making small regular contributions) serve to minimize the risks of owning common stocks to the point of non-existence.
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