401K for Recent Grads: How to Get Started and Diversify In Your 20s

Last Updated on July 13, 2021

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A 401k plan for recent grads? Absolutely! But how do you get started?

The underlying idea is that employees can contribute retirement plans on a pre-tax basis by making contributions that, from the point of view of the IRS, are employer contributions. Early on, the plans were called “salary reduction plans,” which hardly sounded appealing at the time. But don’t worry: there are countless benefits!

401K Matching Made Easy

Now, in 2021, 401ks need less explaining. They are an accepted feature of employment in the United States. Generally, employees choose not only whether to participate in the program, but they also make choices about the ways in which the money will be invested. The employer typically offers a match to the employee’s contribution.

The sensible course for an employee in this situation is always to contribute up to the maximum that the employer matches — otherwise, you’re leaving money on the table.

In a sense, the existence of the fund itself is an example of diversification. Without it, your only source of retirement savings might be your labor power. Now you have introduced another source: your investment choices.

From Conservative to Aggressive

The plans generally offer investments in mutual funds, though recently exchange-traded funds have been added to the menu. The distinction between the two need not concern us here, so we will talk of mutual funds.

The mutual funds will be of four sorts:  conservative, value, balanced, or aggressive. You will have the opportunity to choose among them, or to divide your contribution to the plan among them. So it is critical to understand the terms.

A conservative fund sticks with high-quality bonds and other very safe investments. Your money in these funds will, short of a real cataclysm, grow predictable, though the growth will be slow.

Diversify your 401K in your 20s
If you want more diversification, a value fund will put some of your money into equity. Photo credit: Shutterstock.com

If you want more diversification, a value fund will put some of your money into equity. The equity portion of the fund will be devoted mostly to corporations that offer a reliable dividend stream, so that you are investing for the dividends rather than for stock value increase.

A balanced fund includes some growth stocks amid the bonds and value stocks: that is, stocks that may seldom pay dividends, because their management re-invests income back into the corporation to produce capital growth. If things are going well in the economy, a balanced fund can perform impressively. If things go poorly, it can take a loss — on the basis largely of the failures of those managements with their re-investment plans — though (given the “balance” in the name) the safer components of the mix can limit the extent of the losses even in down years.

Finally, there are aggressive growth funds. These are much less interested in hedging their growth-oriented equity bets. They often depend upon detailed bottom-up analysis of the companies on which they place those bets. But, of course, even the brightest of analysts can get things wrong. Enron seemed like a great aggressive-growth play to many, right up to its collapse.

Diversification

Both of the middle two choices on that brief list — the value and the balanced funds — are diversified in their own portfolio. You, of course, can add another level of diversification by your own choice. You can include a contribution to each of those two, or each of the four possibilities, on our list.

As a general piece of advice: when you are young (between 25 and 35) there is no reason to be afraid of equity. It would be overly timid, certainly, to keep all your contributions within the safety of the conservative funds.

401K Can Be More Aggressive in Your 20s
If you are young enough to ride through the dips, then by all means invest in value funds and balanced funds. Invest even a bit in the aggressive funds. Photo credit: Shutterstock.com

There will be downtimes when the balanced funds suffer a bit, and the aggressive growth funds suffer more. When those times have arisen and your 401k statements reflect those losses, remember: so long as you haven’t cashed in anything you haven’t really suffered a loss. Most of the companies issuing the stock will be back during the next recovery, and almost all of the funds will be.

If you are young enough to ride through the dips, then by all means invest in value funds and balanced funds. Invest even a bit in the aggressive funds. Though there are no guarantees you will almost certainly receive enough payback over the course of the business cycle to compensate you for the shorter term risks.

As you get older and nearer retirement, you’ll want to throttle back a bit on the risks. For now, try to find a middle ground.