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How to Magnify 401(k) Retirement Account Returns

By Charles Hopkins Published 05/24/2007 | Finance

If you have ever cracked open a financial magazine, you have surely heard you should maximize your investment in the 401(k) retirement account if your employer offers one. There are four major reasons to do this: (1) employers normally match a portion of your contributions which means you immediately receive free money, (2) your earnings grow tax-deferred, (3) you reap the tremendous benefits of compounding over decades of reinvesting your earnings, and (4) the Government effectively subsidizes your contributions by reducing your taxable income for each dollar you contribute which reduces your tax bill. It's true; you will most likely never find a better investment for your future besides owning your own home. However, are you getting the full benefits of your 401(k) investments? This article will show you a simple technique you can use to increase your future wealth by tens of thousands of dollars or more.

The "magic of compounding" occurs when you invest money and reinvest the earnings from your investment each month, quarter, or year. By doing this, the next period you have a larger investment which generates higher income. Over the long term, your investment will compound and get larger and larger until you have an amazing balance. For example, if you invest 5,000 one time in an investment that yields 1% growth per month, the magic of compounding will turn your 5,000 into 98,942 in 25 years.

Another popular investment technique most people automatically use when investing in 401(k) accounts is called, "Dollar Cost Averaging". Dollar cost averaging is simply investing a fixed amount of money each paycheck, which generally occurs every two weeks or once per month. By investing a fixed amount each paycheck ... let's assume you invest 200 per paycheck ... your 200 investment will buy more shares of the investment when prices fall and fewer shares when prices rise. Thus, dollar cost averaging takes advantage of share price volatility. There have been numerous studies conducted revealing the net effects of dollar cost averaging. Without getting into the details, let's just say the net effect over 20 to 30 years based on the historical performance of the U.S. stock market; you will boost your average return on investment by around 1% o 2% per year.

Maybe 2% per year on average does not sound like much, but let's consider the example above. Assume you invest 5,000 one time and then add only 200 per month. At 12% returns per year (i.e., 1% per month), your balance would be 474,712 after 25 years. As you can see, simply adding 200 per month provides a tremendous boost over the one-time investment presented in paragraph two. However, if you boosted your average annual rate to 14% instead of 12%, your 25-year balance grows to 608,054. That's an extra 133,342 simply due to the increased effective return.

Clearly, dollar cost averaging adds tremendous value to your financial future, but what if there were another simple way to add another 1% to 2% to your average annual return? As it turns out, there is! It's called, "Asset Allocation", and this is how it works.

First, you should diversify your investments in your 401(k) simply for safety and lower risk. Let's assume your 401(k) offers three different mutual fund investments. For example, assume you have an S&P 500 index fund, a small growth stock fund, and an international fund we'll call the C fund, S fund, and I fund respectively. Let's also assume you are comfortable investing 40% of your 401(k) dollars in the C fund, 30% in the S fund, and 30% in the I fund. These percentages are your "allocation" between investment types. Over time, the growth and decline in share values will vary between the C fund, S fund, and I fund.

For example, over a six-month period, the C fund and S fund might rise by 4% and the I fund might decline by 2%. The end result is the value of your C fund investment and S fund investment will be higher, and the value of your I fund investment will be lower. At this time, the percent of your total cash in the C fund and S fund might be 32% each, and the portion of cash in the I fund might be 39%. If you simply adjust your allocation back to the original 30%, 30%, and 40%, you will sell some of the C fund and S fund and buy some of the I fund. Thus, you will "buy low" in the I fund and "sell high" in the C and S funds.

Six months later, the I fund and the S fund may be higher while the C fund has declined in value. Thus, you would adjust once again back to 30% C fund, 30% S fund, and 40% I fund. Once more, you would "sell high" and "buy low". The net result of re-allocating your cash every six months (or whatever period you choose) will be an effective increase in your average return.

The net increase in average return increases as the total time you invest increases and as the volatility of your investments increases. Furthermore, the more uncorrelated the investment choices in your 401(k) are, the stronger the impact asset allocation will offer. Regardless of these factors, however, you will actually lower your risk and boost your net returns simply by using asset allocation in your 401(k). If the net effect was simply another 2% increase in average annual returns, your new balance in the example above would be 1,048,478.