The 5 biggest 401(k) mistakes

The market may look scary sometimes, but that’s no reason to stay away. Making the wrong moves could really cost you in the long run.

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By Tim Middleton

If you're worried about your 401(k), you have a lot of company. Our Start Investing community has a thread titled "Are you getting enough from your 401(k)?" It has attracted roughly 50 times more interest than any other discussion on that message board.

Many of the posts are along the lines of this one from a member called "Truns": "Sure, I'm worried. Should I wait it out?"

401(k) is free money

Short answer: Yes. The long answer follows.

A great many posts convey the alarm and frustration of folks who are scared to death by something they don't understand. Believe me, once you understand investing, it isn't that scary.

How to plan your 401(k)

"Phil5185," one contributor who knows the subject inside out, wryly notes, "Stocks seem to be the only thing that people hate to buy on sale."

In the testimony of participants on this thread, I've discovered five of the biggest mistakes a 401(k) investor can make. Postings are anonymous (except mine), so I don't think I'll embarrass anyone by sharing these errors with you.

Avoiding them can make you rich. Phil says he participated in his plan for less than 20 years and never got a company match, yet he managed to amass $1 million. "Young people with 30 or 40 years will have some awesome 401(k)s," he says.

Calculator: How much can you save?

Mistake No. 1: Selling when it's time to buy

A 27-year-old identified as "Lucky4jar" complains, "I have been putting more and more money in every two weeks only to watch my total go down and down." His solution: "I have since lowered my contribution rate from 15% to 3%, enough to still get the company match."

It was this post that attracted Phil's retort about stocks being on sale. A bear market is not the worst time to buy stocks; it's the best time. Markets lurch between periods of excessive optimism (the bull phase) and mind-numbing dread (the bear phase). The latter periods correct the excesses of the former, but then they, too, go to extremes.

Over a lifetime of investing, you'll go through a dozen of these cycles, and you'll discover the bear phase is when you make your real money, because that's when you pay the least for the best stuff.

Every month my wife and I make contributions to our brokerage and retirement accounts, and except for a portion of our emergency savings, 100% of that goes into stock mutual funds and exchange-traded funds -- and mostly the risky stuff, such as small-capitalization, midcap and emerging-market funds.

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Mistake No. 2: Trying to 'recoup' your losses

Contributor "Masta Purba" plans to leave her job. She writes, "I have a dilemma: whether to leave the retirement money in the 403(b) account with my current employer for a little bit longer, until I recoup the loss, and then roll it over to IRA, or should I reallocate all the money NOW? (That means I have to sell low and will not have a chance to recoup the loss that has already happened.)"

A field of psychology called behavioral finance was created to deal with issues like this. It turns out that -- surprise! -- people hate to lose money. So one defense we unconsciously deploy is to defer acknowledging losses by vowing to recoup them. If you get back to even, that's proof you didn't make a mistake in the first place, right? You don't look so dumb.

But hanging on can be even dumber. Stop and think about it: Your investments are worth today's price today. All investments are. Markets go up and down together. You will recoup when the market -- the whole market -- goes back up.

Masta Purba realizes her company plan is unnecessarily costly, as are most 403(b)s. These are the versions of 401(k)s for teachers and other employees of not-for-profit institutions, and nearly all of them are expensive insurance-company programs. She is thinking about moving her money to Vanguard or T. Rowe Price, both outstanding and economical investment managers.

My advice: Do it immediately. These better managers will lose less of her money, and the lower costs will leave more dollars in her account, not theirs.

Mistake No. 3: Seeking 'safety'

"Pat63" laments his lousy choices, saying he can find better interest rates for his savings outside his retirement accounts than he can inside. "I'm curious as to why there are no similar accounts for IRA or 401(k) rollover amounts that would alleviate anxiety, instead of everyone being herded to investing, which is gambling with one's future no matter what it is called," he writes.

Actually, pension-plan savings accounts, usually called stable-value accounts, are one of the most popular 401(k) options. They are also the very worst. For one thing, they don't pay money market interest rates; the one in my wife's plan is currently paying 3%. These are, after all, crummy, expensive insurance-company products.

The inflation rate is topping 5%, so in terms of purchasing power, you are losing money from the outset. And when you take the money out in retirement, it is taxed, so you lose again. You could end up with 80 to 90 cents of every dollar you put in. Pat is right about one thing: Putting money into stable-value accounts isn't gambling. Gambling gives you a chance to win. You can't win with these things.

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You can manage investment risk, but you can't avoid inflation and taxation. Save instead of invest and, unless you started as a millionaire, you will die broke.

Mistake No. 4: Blindly following conventional wisdom

There are many truths in investing, one of which is "Don't chase performance." It's a great rule of thumb because that which is hottest is most apt to turn cold. But it presumes you know how to use a thumb.

To take one current example: I wrote a version of this column at the beginning of 2008 and cited UltraShort MSCI EAFE Index ProShares (EFU, news, msgs). It is designed to go up twice as much as this key foreign-stock index goes down. At the time, it was up 22.7% in less than three months. But it was just getting started. By mid-August, it had shot up 43.7% in 2008.

A poster nicknamed "Crashnburn5990" writes: "I have looked at inverse (ProShares) funds and am holding off on buying them just yet. For the most part, they have just spiked, and I am really (leery) of buying a fund that has just spiked. I'd much rather buy a fund that has apparently bottomed out and is just passing through its 50-day simple moving average."

D'oh! If you wait for this fund to bottom, the bear market will be over, Homer. And that won't be a great time to buy a bear market fund.

Mistake No. 5: Timing a market meltdown

Over at Start Investing, "Gator Trader" thought he had the latest bear market figured out. "Wait for (the market) to bottom," he advised. "I think that would be the easy way out and seems like the right thing to do. There is a bottom, and we are about six months out. Why six months? Because that is about how long it will take for the recent moves to mature."

I would love to call the bottom, too, but I can't. Neither can anybody else. Eight months after that forecast was made, markets were lower -- with no relief in sight.

The recession-induced bear market of 1990 -- which produced losses of about the same magnitude as the current downturn had generated at the start of 2008 -- lasted little more than three months. But the recession-induced bear market of 2000 got twice as bad as what we've seen in this pullback, and it lasted 2 1/2 years.

(And what if we're not in a recession? According to research by Hussman Funds, bear markets not related to recessions last an average of 215 days, compared with 491 days for recession-induced bears.)

"Capitaloss," meanwhile, has a 401(k) plan that allows him to invest 100% of his annual contribution at the start of the year, and he asks, "Should I invest it all (as soon as possible) or dollar-cost average over the first half of the year?"

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I would take advantage of the plan's flexibility and put it all down right away. Capitaloss is in his late 30s; putting down 100% on Day One of each new year is a form of dollar-cost averaging, which he can repeat for decades. Meanwhile, he puts money to work at the earliest possible moment, maximizing the benefits of compounding.

Most 401(k) participants contribute a portion of each paycheck, which is classic dollar-cost averaging. But if you have flexibility, such as with individual retirement accounts, lump-sum investing produces higher returns two-thirds of the time. So instead of funding your 2008 IRA on April 15, 2009, fund it today and give yourself extra months of tax-deferred compounding. Plus the odds are greater that stock funds are cheaper today than they will be in eight months.

It's too bad most American workers know too little about investing to take full advantage of their 401(k)s. It doesn't take a lot of effort. Mostly it takes confidence, and confidence comes with experience. Bear markets are painful for seasoned investors, but they are not alarming. They come like winter, and like winter they must -- and do -- depart.

At the time of publication, Tim Middleton did not own any securities mentioned in this column.

Produced by Elizabeth Daza/Graphics by Joe Farro

Published Oct. 1, 2008