Misconception Monday: 401(k) Returns

I got a question recently that I want to share. It’s rare to find someone that has such a unique question that nobody else can learn from it.

I was speaking to someone about retirement accounts and the options for investing for someone in their 20s. Of course, the first thing I suggested was the mandatory 401(k) match, followed closely by the Roth IRA. In this specific case, there was no match available, just a traditional 401(k). So he wanted to know how much he could make investing with Lending Club, and IRA, and a 401(k).

We talked a little bit about how the Lending Club returns can be great, but is a little more involved as you have to choose the specific loans you want to invest in.

Then came the big question:

“So how much does a 401(k) make?”

Time for a quick refresher: You should always have control over your investment accounts. Whether you want to take risks with the hopes of earning higher investment returns is up to you, but almost all investment options come with variable returns.

You can’t simply say “I want to earn 7% each year, so I’ll invest in an index fund that tracks the S&P 500.” In some years it will work out, but in others it won’t.

Within a 401(k), there are many investment options. My options include some very conservative options, some benchmark index funds, and even some more risky funds that track emerging markets. I chose a nice mix, but people in different stages of their life will make different choices.

So the answer to the question?

There is no set return for a 401(k) (or IRA or other investment account), and the risk/reward is completely up to you.

The other lesson to be learned here is that investment options shouldn’t affect the type of account where you invest your money. Instead, the tax advantage and flexibility should be the major factors that affect your decision.

For example, a Roth IRA is great both for the tax benefits AND the flexibility of being able to withdraw contributions (and only contributions) at any time. And in my situation, the investments options are the same, so these two factors are the only ones that affect my decision.

Readers, what affects your decisions on how to invest? Which investment vehicle is your favorite?

4 Responses to Misconception Monday: 401(k) Returns

  1. Evan says:

    I think it is my personality but I want a little bit of everything. I am fine with the fact that my 401(k) won’t “make” anything, but at the same time, I’d like my dividend account to provide me with a cash return (eventually since I just reinvest right now).

    Sounds like your buddy would be more interested in bonds or fixed income investments. You should have him do a risk tolerance/asset allocation questionaire

    • Daniel says:

      @Evan, Actually just the opposite. For the retirement accounts, he realizes he has a ton of time and is willing to take on a lot of risk. He’s going with Roth IRA for retirement and Lending Club in the short-term.

  2. Valerie says:

    The variable risk/reward is both great and unnerving. I like certainties, so I would really like some guarantee of a return. It’s rather frustrating for me contemplating how the market may or may not do, and guessing at what my returns may be then.

    On the other hand, I’m not willing to settle for miniature returns on bonds and fixed income, so I end up going for substantial risk (particularly since I’m young). Still, I really wish I could say, “My 401(k) earns X% a year!”

    • Daniel says:

      @Valerie, Of course I’d like the guaranteed high returns and I though that investing, even in my retirement, would drive me crazy because I would be checking my balance too often. After about 2 weeks, I forgot about it and rarely check it. I’ll evaluate my account a few times a year, but for the most part, I don’t think about it and don’t worry at all!

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