I currently invest in the stock market in both pre-tax and post-tax accounts. I’m in the process of developing my knowledge and skill at fundamental security analysis (analysis of a company via their finances AKA The Numbers!).
Compound interest has been referred to as “the 8th wonder of the world”, and rightly so. Over time, compound interest can generate incredible amounts of wealth – Someone like Warren Buffet is a prime example of the power of steady long-term compounding interest.
401(k) contributions can be directly taken from your paycheck without being taxed, which means that even though you get “less money” to live on, you won’t suffer a 1-for-1 hit to your take-home pay by contributing. If you can afford it, a 401(k) contribution is a fantastic way to start saving for your future.
At first, it can seem a little pointless, or like your account isn’t doing anything. It might seem like it’s better to wait until you’re making more money to start contributing.
Let me show you graphically why that’s not true.
I plotted two examples below. Person A starts contributing 5% of their paycheck at year 1 of employment, and makes $50,000 per year. Person B starts contributing 5% of their paycheck at year 10 of employment, at which point they are making the same amount as Person A ($65,238.66 per year). I assumed each person’s salary increased by 3% per year every year, and they never changed their 401(k) contribution. I also assumed each person’s 401(k) account achieved a 7% rate of return, simply compounded annually. Check out the difference at year 35 of employment:
At 35 years of service, Person A will have roughly 65% more money in their account than Person B!
Does your employer offer a 401(k) match? If so, you are throwing away free money if you don’t take advantage of it. Some employers will match, say, 50% of your contribution up to a maximum of some percentage, such as perhaps 8% of your pay. That means if you contribute 8% of your pay, your employer will contribute the equivalent of another 4% into your 401(k). That’s huge. To put the impact of that in visual format, check out another plot. In this case Person A contributes 8% with a company match of 50% of their contribution, and person B contributes 5% with the same company match (both start at the same time, year 1):
Now Person A has over $1.2 Million by the time they retire, while Person B has roughly $800,000.
What’s the bottom line? Start contributing early if you can afford it, and take advantage of any and all company matching that may be available to you.
As to what to invest your 401(k) funds in, that is between you and your financial advisor. I have found through some research that very few if any fund choices can do better than a simple S&P 500 Index fund over the long term.
My after-tax investing is mainly value investments with a very long-term, buy-and-hold approach, and some shorter term speculative investments. In a nutshell, I attempt to find companies that are making money, have a solid history of good earnings, are well established in their market, and that are currently trading for much less than what their “intrinsic value” may be. Many, many books have been written on the subject of value investing and fundamental analysis and I encourage you to seek out knowledge in this area if it interests you! A great place to start would be to read “The Intelligent Investor” by Benjamin Graham.
I have a lot to learn, but I’m excited to get there. I think my next post will be a fundamental analysis of a company I am considering for investment, with my own personal spin on how I approach estimating value. If you’re interested in value investing, or fundamental analysis of securities, drop a comment below!
Wondering who I am? Want to know what the game plan is for this blog? Check out my Introduction!