This is a guest post from A.J. Clark, a long-time lurker at Get Rich Slowly. A.J. is a potential Staff Writer for GRS. He is a recent college graduate who writes software in the financial services industry, while trying to find his financial footing in the Real World. In his first post, A.J. explained that he’s hoping to finish ahead by starting behind.
As I mentioned in my previous post, I recently transitioned into my role as a salaried employee at my job.
Along with the increase in work responsibilities, I am now eligible to receive a variety of benefits from my employer, which include various forms of insurance, a 401(k) plan, and other fringe benefits such as flexible spending accounts for health-related purchases.
In August, I will make my first contribution to a 401(k) plan, which is quite a big step for me considering how much debt I have left to pay off. After all, every dollar that I put into my 401(k) plan I could be using in other ways — to make a principal payment on my student loans, or to further build my emergency fund.
On the surface, not making a principal payment on my student loans does not seem to carry a large opportunity cost. However, the majority of my student loan debt is tied up in two high-interest student loans from a private lender, with over $25,000 currently carrying a 10% interest rate that will change whenever the Federal Reserve alters the federal funds rate.
Theoretically, student loan debt is supposed to be on the same level as mortgage debt, in that it should not be a burden on the borrower, and is regarded as a “good” debt to have. Due to their interest rates, my private student loans are on the same plane as my credit cards, and therefore should be paid off as soon as possible.
Losing My Appetite
Since I receive matching contributions from my employer to my 401(k) up to a pre-determined dollar amount, the decision to contribute to my 401(k) was not difficult.
For instance, suppose my employer matched the first $1500 of contributions that I made to my 401(k). This means that if I put $1500 into my 401(k), I would receive $1500 dollars from my employer at the end of the year — an effective return of 100% on my investment!
When I initially thought about contributing to my 401(k), I thought that I would contribute only enough money to receive the full match from my employer. “Why be greedy?” I thought to myself; 100% interest is much better than what most others are receiving on their investments.
When I had this mentality, my appetite for risk completely disappeared. I wanted to grab ahold of the 100% return that I thought I would be receiving, and not let go of it. I wanted to invest my entire 401(k) portfolio in long-term treasury bonds, to ensure that the principal amount that I invested into the plan would be safeguarded from the current market turbulence. I did not want the market to cause me to lose money that I worked hard to earn, and wanted to see saved.
Thinking about a more diverse (and aggressive) portfolio was simply out of the question; I needed to safeguard my fictitious principal balance at all costs. The voice in the back of my mind frequently reminded me that the money in my 401(k) could be paying off high interest debt instead, and that I should be careful with it.
Getting Hungrier
What I failed to realize is that putting money into a 401(k) is a long-term, life-altering decision, especially at my age. As far as I know, my parents have little to no money saved for retirement, and they are much closer to retirement age than I am. Yet, I am twenty-one years old, and despite the ridiculous amount of debt I am in, I am still able to make a meaningful contribution to my future, one that will hopefully allow me to end up in a better place than my parents are.
With the help of a family member, I realized that the money that I am investing now I am not going to need to use for at least another forty years. He convinced me that I am in a position now where I can afford to take a moderate amount of risk, and be reasonably aggressive in my asset allocation, whereas thirty years from now this will not be the case.
Although I still shudder at the thought of my investments significantly decreasing in value, I realized this week that I should not concern myself with the day-to-day ups and downs of my portfolio. I also learned that I should try and focus on the fact that I am saving money to secure my financial future, and that short-term losses will eventually be trumped by long-term gains.
Unlike many other individuals, I did not lose a lot of money during the recession because I did not have any money invested in the markets to begin with. With a greater appetite for risk, I can be sure that I will not miss out on the inevitable upswing in the markets, and I will be able to further grow my investments, and secure my future.
Let me ask you: What is your appetite for risk? Does your age have an influence on it, or do other factors significantly affect it?
This article is about Ask the Readers, Choices, Investing, Planning
SEARCH FOR RECENT ARTICLES
What this post doesn’t talk about, but should, is dollar-cost averaging. In this type of market especially, putting your 401k investments in moderately risky vehicles works out very well because of dollar-cost averaging. Making monthly investments of the same amount no matter what the market is doing allows you to average out the volatility that we are seeing now, thus lowering the risk factor that normal investors are dealing with.
loading....
I love the readers’ comments, but the discussion is better when the main article is stronger and more provocative. And JD might have missed a couple of edits, but if he has to edit every post from the standby person, he’s not getting a lot of value added.
It would be interesting to get quarterly or annual updates from AJ to see how he and his money are growing.
loading....
My risk tolerance is what it should be for a 24 year old–very high. I have ALL my 401K in stocks (44% S&P index, 40% international fund, 8% mid-cap growth, 8% small cap growth). On my mid-cap stocks I am up 31% for the year. The others are all over 10%+ growth for the year. Now is the time to buy stock–they are essentially on sale! As long as you do it consistently, over-time, and remember to diversify with funds that have low cost ratios (indexes are great for this, as many of you know), you’ll be fine. If I had the patience I’d do some calculations that show that you CANNOT afford to not put your money in stocks. The average middle-class person will never save enough to retire on by investing in bonds, even if you start at 24. It’s just not possible.
Also, the cardinal rule of interest rates vs. bond prices is that when one goes down the other goes up. Therefore, it’s crazy talk to want to buy bonds with interest rates so low. I don’t even look into them. Wait until interest rates rise if you are set on buying bonds and don’t want to lose your money.
loading....
I think as long as you diversify, and follow an asset allocation that you are comfortable with and not out of line for your age, you are good.
I’m 24, 10% bonds, 15% international, and the rest S&P500. I had company stock which vested and threw my asset allocation out of line, and I was really anxious to just get out of that so I have my risk in line with what I am comfortable with.
I can handle risk up to the point that it doesn’t fluctuate my net worth that badly. I do recognize that my portfolio will fluctuate my net worth more as I grow older…and I’m not looking forward to that aspect of it.
loading....
This article seemed to be targeted to a younger audience first starting out with retirement accounts – lacking a little is substance and a little too much bravado. Doesn’t seem like you can ignore the matching contributions = free money – but that doesn’t mean you should put more than that in, especially when you’re paying 10% on a student loan.
loading....
“I can be sure that I will not miss out on the inevitable upswing in the markets”
INEVITABLE??? Nothing is inevitable except change. I was recently at a meeting with a rep from a major mutual fund company, and he pointed out that of the (I think it was) 107 instances since they started counting where the stock market lost 10% or more, the market has come back from 107 of them…
It got me to thinking, as someone who’s studied statistics, that this may not be a big enough sample. Yes, we’ve come back from everything so far, rebounding nicely. So far. But some things to think about:
1. The US has been a world power since after World War II, say 60 years now.
2. There are quite a few signs that we’ll be one of the shorter-lived world powers. I mean Rome was IT for 500+ years, right?
3. Japan has languished for almost 20 years now.
4. Taiwan (the other country I lived in) has a very cheap stock market, because it doesn’t grow – it goes back and forth between a high and a low (support and resistance), and has for years.
Recovery isn’t inevitable.
That said, I do think it’s likely. Fear of the markets not recovering certainly isn’t keeping me away. But I do watch my money closely, and don’t assume that ‘it must go up’.
Oh, and my risk tolerance is probably higher than most, as I like to trade…
loading....
I agree that the content of this post is a bit amateurish. You talk about risk, but you really mean market risk. You forget about the big invisible elephant that most people fail to think about, INFLATION risk (as Adrienne in comment #22 pointed out):
http://www.forecasts.org/inflation.htm
I consider myself to be pretty conservative and risk averse, but the thought of inflation eroding the value of my money scares the crap out of me. So, I’ve been contributing the maximum allowed to my retirement funds ever since I started my career 14 years ago, and am almost entirely invested in the stock market.
Given that I have nearly 30 years before I reach retirement age, I can handle the short term volatility of the stock market. I do plan to slowly shift my assets into more conservative investments as I get closer to retirement age, however.
Also, for those that choose to trade actively, you may want to check out this study:
http://www.qaib.com/showresource.aspx?URI=advisoreditionfreelook&Type=FreeLook
Over the past 20 years, the average active investor managed a paltry 1.87% return, while the S&P 500 provided 8.35%. The lesson? Passive investing is the route to go for most people.
loading....
I am fully aware of inflation risk, and what it can do to one’s investments. However, inflation risk is negligible with the situation that I presented. Let me clarify:
With my employer match, I am effectively receiving a 100% return on my investment. I put in 1,500 dollars, and I get 1,500 dollars from my employer. If inflation erodes 3 or 4 percent of that away, it doesn’t matter too much to me in the short term, because I made 100% interest on the initial investment through the match. In this scenario, assuming I put my portfolio in risk free investments, I am able to safeguard my principal.
Allocating my portfolio more aggressively exposes me to market risk, which was what I discussed in the article. I was not fully convinced that exposing myself to a potentially significant amount of market risk was worth it, considering that I have so much student loan debt to pay off. The issue that I struggled with was whether or not I would pay off my loans faster with this money, or invest in my future — I chose the latter.
@The Community:
As far as my knowledge of personal finance is concerned, I am still learning, and am open about this point. Perhaps an “Ask the Readers” post was not appropriate for a second submission for a Staff Writer position, and if this is not what you would have liked to hear from me for a second go-around, I understand that.
As far as the vague-ness of the article is concerned, when I wrote it, I had not yet gone through my options of asset allocation to formally split my money up. I would like to share this process with you, and how I ultimately selected which vehicles I invested in, but it is really the topic for another post.
loading....
I am extremely risk averse. Nevertheless, all my Roth IRA money is in stocks. I started contributing just the amount I thought I could lose without impacting my life. Then I moved up to contributing double the amount I could lose, because I decided that it would be unlikely for the market to completely melt down; worst-case scenario was more like losing half my money.
Now I know that there is no way to eliminate risk. Even with all your money in bonds, you still have the risk (actually, an extremely high risk) that inflation will outpace earnings. The only way I know of to reduce inflation risk is to put some money in stocks.
The best strategy I can think of is to diversify. I hate the way people who talk about diversification only talk about stocks and bonds. Surely there are other things to do. Currently, I have a really good pension (which is very bond-like), so my other retirement money is in stocks (and I will be moving some into REITs, too). I also bought a house, which will be paid off before I retire, so that reduces the amount of money I’ll need. (And if I’m wrong about that and my taxes and insurance costs skyrocket, that probably means my house would sell for a lot, so I could sell it and move someplace cheaper.) Other ways to diversify include keeping up job skills and learning to do more things yourself so you don’t have to hire people.
When I retire, I will move some of my investments into bonds or CDs or something else “safe”—20% if it looks like stocks are bubbling, very little if we’re in a horrible recession, but otherwise probably 10%. Then I’ll withdraw a certain percentage of my stocks each month—if it’s more than I need, I’ll buy more bonds or CDs or whatever. If it’s not enough because of all the plummeting, I can get some extra from the bonds/CDs.
I would say my age has had no effect on my appetite for risk—I’ve always been risk averse. But my experiences have shown me that—too bad for me—I have to deal with risk anyway. So now I look at how to balance various risks to maximize my chances for fun and happiness.
Age and experience have mostly just made me better at understanding my options, which kinds of risk are associated with each, and just knowing how many options I have. Actually having money invested certainly motivates one to start paying more attention! And by starting to invest early, you can experience some freak-out situations while you still have very little money to be screwing up with, so that by the time you have a significant amount invested, you’re not quite so ignorant.
P.S. I am 46 and plan to retire in 5.5 years.
loading....
@A.J. – thanks for your response. In your case, it’s not really about risk then. It’s more about which has the bigger payoff: contributing to your 401k (regardless of the investment fund choice) or paying down your student loans? That is really a different topic than your article title. It’s pretty simple to do the math and see what the rate of return for each option is.
Given that most student loan debt cannot be wiped out by bankruptcy, I think it makes sense to attack that after contributing to get the match on your 401k. However, some experts, such as Dave Ramsey, disagree, and promote debt elimination first. I think you’ll come out ahead either way. Anyway, good luck and thanks for contributing to GRS.
loading....
@azphx1972 (#60)
The issue of contributing to a 401(k) or paying down student loans is not as clear cut an issue — you are right, is a different topic than what I wrote in the article. In the article, I chose to only write about investing in the 401(k); although I alluded to the opportunity cost of what I could do with my money (pay off my loans) I did not want to make that a focal point of my discussion.
Also – thank you for contributing as well. Without someone being critical of articles and raising tough questions, the content in the site would probably not get better. (I think, at least).
loading....
JD,
I know we don’t get a vote in picking the new staff writer, but there are a lot of duds so far. Candidates I think are worth a shot are April, Karawynn, and Baker.
loading....
These past few days have been strange not having JD’s voice around. I actually can’t wait until these tryouts are over.
loading....
Looking forward to the end of the auditions…
loading....
I’m not sure what appetite for risk means exactly. I have generally had allocation that would be considered somewhat non-aggressive for my age (although I guess I have essentially grown into an allocation of “age = percentage bonds” over time).
But I generally care little about the dips in the market, and in fact I looked at the ‘panic moments’ of the past year as a opportunities. As a result my timing was pretty darned good (not that I believe in market timing, but hey you simetimes get lucky).
So my allocation is moderate but my attitude is aggressive. What’s my appetite for risk then?
loading....
About two years ago, right as the subprime mess was unfolding, I decided that I wanted to invest in mutual funds. At that point, the full effect of the crisis was yet to be seen and many thought it would be contained to the US. I jumped head first in and made an initial investment of 2000€. I actually saw the value increase the first few months. Then came the crash and what a crash it was. The value dropped roughly 40% and I cursed myself for being so eager to get into the market. However, I still continued buying shares each month, as planned, probably mostly because I didn’t know what else to do.
I have a hard time saying exactly what my current appetite for risk is and how it differs from my mindset of two years ago. It’s more that I’m looking at investing from a new perspective. In retrospect, I think the market tanking was a good thing for me personally. Prior to it, I sort of envisioned the market as an amazing vehicle for getting massive gains on my invested money. The crisis bitch slapped me into reality and made me think less about market movement, of which I have no control over, and made me focus on things that I CAN control, like asset allocation and minimizing costs. Because of this, I found a couple of low cost index funds that I’m now saving for retirement in. To quote Tico Torres, the drummer in Bon Jovi: “whatever was good was great, and whatever was bad was good because you learned something from it”.
loading....
I’m 38, planning on retiring in 15-20 years, I have 100% allocation in stocks and I look at the down market as a chance to buy more. If anything, I’m looking at moving more into international stocks to increase my risk (and therefore my reward).
I plan on leaving my allocation completely in stocks until maybe 3 years before I start withdrawing it. At that point, I plan on continually pulling it out to a cash account at the rate that I will spend it in 3 years time – the rest stays in stocks. I think that this plan keeps you on the “efficient frontier” while smoothing out any bumps in the market.
loading....
Over the long term nothing beats equities and I intend to stay 80-100% invested in them for the rest of my days. The important thing I think is to invest in either index funds which both minimize costs and maximize diversification, or buy companies such as Johnson & Johnson, McDonalds, Coke, Wal-mart etc… that you know will still be selling goods to your grandkids.
loading....
“student loan debt is…regarded as a ‘good’debt to have”
Wow. Quite an interesting statement I vehemently disagree with. It’s NOTHING like a mortgage because after you pay it off you don’t have a valuable asset–you have nothing. Please don’t tell yourself (or others) this lie. Instead, work as hard as possible to knock out this obligation as quickly as you can to free up your money to do greater things with your life.
loading....
Golfing Girl (69)–Having worked in credit for many years and being fully familiar with the mindset that produces and sustains it, I couldn’t agree more!
We do a psych job on ourselves (aided generously by the culture) to convince ourselves to take on debt for this or that “noble purpose”. And always it’s to facilitate buying something we otherwise can’t afford, or refuse to consider less expensive options for.
Debt IS risk, and we’ve all become too comfortable pretending that it isn’t.
loading....
Student loan debt (especially of the federal nature) is usually low interest (3-4%), and is able to finance an education that those who take out the debt for would be unable to attain otherwise, and generally increases one’s earning potential in life. About 15,000 of my loans are federal loans, and carry a relatively low interest rate, and I would not mind taking longer to pay them off if necessary, if it meant that I could use my money in other ways, such as investing.
To finance the rest of school, my parents did not want to take out a Federal PLUS Loan for me, even though they generally have lower interest rates than private student loans. Again, PLUS loans are generally low-interest, and regarded as an investment in one’s future — ignoring the fact that it IS debt. I think they can be regarded as “good debt” as well.
My parents co-signed one of my private loans with me, and their credit history luckily gave me a break I needed on the interest rate for some of it. However, they were not able to co-sign on all of my loans, and as a result, I got slammed on the interest rate when I took them out on my own. At the time, I had little to no credit history, and was a huge credit risk to the company (which I understand). On this portion of my debt, the interest rate will be pushed up to the neighborhood of 15% once the federal funds rate is restored to prior levels over the next few years. This clearly is not the “good debt” that student loans are supposed to represent.
loading....
I only have two comments in regards to this post.
I am a part time college student majoring in finance with a full time job. Whenever the questions of how risky your asset allocation should be, regardless of what the market has been doing over my several years in college, the answer has always been simple. Take 100 minus your age, the result is the precent that should be in stocks. The rest should be a more guaranteed return (bonds and the like). Simple. I live by this.
Second, yes, the market has dropped. Yes, it is a scary time. But what does Buffet say? Be greedy when others a fearful and fearful when others are greedy. Amen, Buffet. Amen. It is better to get into stocks now then when they increase. The Toyota stocks I purchased back in March are up over 30%, would be more if I had bought sooner, but I was fearful! There will always be risk in stocks. When things are low you have of a way down then when they are high!
loading....
From what I’ve seen, “good debt” is debt that makes more than it costs – you end out ahead in the long run. A mortgage is good if you make more (in appreciation or rental income) than you pay the bank.
School loans are good debt if the education will increase your ability to pay it back fast.
No debt is good when you have the money to pay it off and don’t. Then there’s bad and less bad…
loading....
At 50 I have been investing in IRAs since 84, the max limit for all years with exception to a couple years. I have less to show in my account than I invested not even counting divs reinvested. I followed the rules investing in growth mutual funds early with big investment houses. I recently changed to target funds in the past few years. I put this year’s investment in a 7 year cd so as to have something more than what I put in. Yes, I know inflation will whittle away at it but I feel that I gambled and lost with the growth funds. I dca’d with my annual investments too. My spouse’s IRA did slightly better, at 1% return. We are retired and rolled our piddly 401Ks into Energy mutual funds and so far have made back some of the value lost. My 401K was with the state of CO and for the last year I worked I tried to put the max contribution in. They didn’t have a MM option so I lost about 30% of the final year’s investment when I transfered it into an IRA last November. Both my Roth IRA, reg IRA amount to chump change, such a small sum, for the value of it and I will let it grow for the next 20 years. In Hindsight I would have been better off with the compounding of investments by putting the funds into cds at my credit union. Einstien sremarked on the value of compound, shame on me.
loading....
One thing I don’t understand about the posts here: why when you talk about diversification you only talk about stocks and bonds. Not only that but when you talk about bonds you really mean bond funds which could be fine but they aren’t at all the same as individual bonds.
For example the author above says “I wanted to invest my entire 401(k) portfolio in long-term treasury bonds, to ensure that the principal amount that I invested into the plan would be safeguarded from the current market turbulence.” But the treasury bonds in 401Ks aren’t usually individual treasury bonds that pay you fixed interest and are guaranteed to return you the money at maturity or I bonds or EE bonds which you can cash at their face value plus interest. Nope, treasuries in 401K are actually treasury bond funds and as such they are subject to market fluctuation. Treasury bonds went up in value a lot during the crisis because of “flight to safety” – all the big investors buying individual treasuries. They have fallen since then. Last March Buffett talked about “bubble” in treasuries. How long do you think everyone would be willing to lend money to the US at these low rates? As soon as the demand for US treasuries drops, the interest rate on treasuries will go up, and the value of treasuries in treasury bond funds will drop as well. Treasuries are a safe investment except for inflation – you can always hold them to maturity. Treasury bond funds don’t come with a maturity date. When you sell them, you sell them at the current market value. Hence the treasury bond fund is not at all safe. The only part of 401K where you are promised to keep your investment is stable value fund – which is a reasonable part of your portfolio especially if you are risk averse.
Cash is a perfectly valid part of a portfolio as well. If you had cash in November of last year and in March of this year then you could use it to buy stocks cheap. At about the same time, many investment grade bonds – corporate and municipals – were selling at large discounts and hence with ridiculously high yields because of the credit crisis, so those with cash in their portfolio could’ve taken advantage and buy bonds – individual if you have enough money, bond funds if you don’t or if it is in 401K. I did a bit of both, by the way, though not as much as I should’ve. Having cash as one of the assets and not just “emergency fund” is a perfectly reasonable choice and provides for flexibility when there are opportunities. Yes, cash loses value in inflation. But how much are we really 100% sure that we’ll get inflation and not deflation?
But, if we are really sure about inflation, than commodities is a reasonable choice as well.
As to bonds, if you talk about bond funds and not individual bonds that you plan to hold to maturity, than bonds can lose value. There is also risk of defaults as with individual corporate and municipal bonds. Last fall corporate and municipal bonds lost value because of the credit crisis and fear of defaults. At the same time government bonds went up in value. Since then government bonds lost a tiny bit of their appeal, but corporate and municipal bonds are considerably up. But if the interest rates start going up, the value of all bonds will drop. This is something everyone who invests in bonds should think about.
loading....