Roadmap to Riches   
how to invest your 401(k)
The Fundamentals: Time, Risk and Return
Time - The time-frame of goals
Risk - A self-assessment of risk-taking ability.
Return - An appreciation of what higher returns can accomplish.
Keeping the fundamentals uppermost in our minds will be a key factor in the successful outcome of our 401(k) investing over time.
The man who knows more about time, risk, and return than anyone else in the United States today is Warren Buffet, our second-richest citizen. Here is some advice from his book, The Warren Buffet Way.
“Fear and greed move stock prices above and below a company’s intrinsic value. In the long run, the value of stock holdings is determined by the underlying economic progress of the underlying business; not by the daily stock market quotations.”
“If you expect to purchase stocks throughout your life, you should welcome price declines as a way to add stocks more cheaply to your position.”
The future is never clear. What we do know today is that there are well-managed companies that consistently make money, and the stock market values them periodically at foolishly high or low values.
Buffet recognizes that he is neither richer nor poorer because of the market’s short-term fluctuations in price, since his holding period is longer term. As Buffet puts it, he would not care if the stock market closed for ten years — it closes every Saturday and Sunday and that has not bothered him yet.”
How Do We Apply That Same Wisdom to Our 401(k) Money?
For openers, Time, Risk and Return are the three “engines” driving our thought process as we begin to match our goals and objectives with the investments being offered in our 401(k) plan.
Time
Of the three “engines,” time is by far the most important. This is why nailing down our goals and the time they will require is so critical a step in the investment decision-making process. After a discussion of risk and return, we will revisit the impact of time.
Risk
Risk is a measure of the possibility that we might lose money. The most obvious loss of money is an actual reduction in our account balance during what might be a bad quarter for our investments. This experience is always difficult for us even when we know that the loss will probably be only temporary.
The fear of the unknown is always lurking somewhere in the back of our minds. We’re thinking, “This time it’s different. This time it’s really doomsday!”
The key words above are “fear of the unknown.” The more we educate ourselves with regard to investments and how they accomplish their miracles, the less the fear factor will influence our thinking. President Franklin Roosevelt once said, “All we have to fear is fear itself.” The underpinnings of risk have more to do with emotion rather than rational thought. However, there are some mathematical measurements of risk that may satisfy those of us searching for more order than the “casino atmosphere” that is seemingly offered by the stock markets in general.
A more subtle form of risk is the inflation that eats away at the value of our retirement accounts. As time goes by, the goods and services we buy become more expensive by a few percentage points per year. The few percentage points of inflation tend to be mirrored, year after year, by the rate of return on money market funds or any short term savings programs. Therefore, while cash reserves may seem to be making money each year and offer the guarantee of never offering a year of losses, they offer no gains beyond just the rate of inflation.
Return
Return comes to investors when they own something or loan something. We own something when we invest in stocks. We loan something when we choose funds that invest in bonds. Even money market funds are a form of bond investment although the “loans” are for very short periods like just a few months. For this reason they are called notes. Loaning something in the context of your 401(k) plan means choosing an investment that invests in bonds or notes.
Owning something in the context of your 401(k) plan means selecting an investment choice that invests in shares of stocks in different companies. When you own stock in a company your stock represents an ownership share in a business.
Any business that makes a profit is free to apply those profits in one or a combination of the following ways:
- It can pay them out to owners each year in what are called dividends, and/or
- It can reinvest them back into the company to increase the company’s size and value so that owners can sell the company itself in future years for more than they originally invested.
- In the end, whether your 401(k) investments are in stocks, bonds, or a combination of both, your Return will consist of the following:
Yield
The amount of dividends or interest paid by the stocks and bonds your investment selections have chosen as investments.
Total Annual Return
This is the total increased value of your account starting with the yield and adding to it any increase in value of the stocks and bonds your investment funds own. The total increase in value of all these sources will constitute the total annual return of your 401(k) account balance.
How Do Time, Risk and Return Relate?
Why is risk worth taking? Because people who can endure more risk can expect a higher return as long as they have given themselves enough time to recover from the periodic market downturns.
Over the past fifty years, the market has dropped at least ten per cent 33 times. When J.P. Morgan was once asked what the market would do, he said, “It will fluctuate.” The following matrix illustrates the amazing degree to which risk-takers can be rewarded over time.
$10,000 Per Year Investment
Time is to Investing, What Oil is to Engines
Time oils the workings of any investment program and offers an element of forgiveness. Economic history shows us that the risk of losing money evaporates if we have enough time for our money to work throughout a series of stock market cycles. The following table illustrates the forces of time in its ability to iron out the volatility of rising and falling markets. The graph illustrates that with rolling ten year periods, an investor in the American stock market would have had almost no ten-year period of losses. In other words, since 1929, any stock market investment spread across all the stocks sold in the stock market would have earned a positive return if left in for ten years.
Understanding the relationships between Risk, Reward, and Time is a critical component of any hope for success as an investor. A thorough appreciation for these fundamentals sets the stage for a more “set-it-and-forget-it” or an “automatic pilot” approach to investing which usually leads to the best results over a long period of time.
While the average mutual fund has increased in value at a rate of 15% per year for the past fifteen years, the average mutual fund investor has only gained 3% per year. Why? Because the average investor has been chasing last year’s best investments or switching in and out of the market at the wrong times. Terrible investment results are only a symptom. The disease is a lack of understanding of the fundamentals - Risk, Reward, and Time.
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