Your 401K plan offers a natural way to dollar cost average
Dollar cost averaging has been proven to be a good investment strategy for a variety of reasons: 1) you are not overexposing your investment to the risks involved in timing the market 2) you consistently invest your money on a regular, periodic basis.
Consistent investment is one of the keys to becoming a successful investor. Following a dollar cost averaging strategy ensures that you are maximising returns to your investment without unduly taking chances that might affect it negatively and also protecting your hard-earned investment from the fluctuations in the market. In fact, dollar cost averaging takes advantage of market volatility so that you buy more stock when the price is low and less stock when the price is high.
This prudent approach to investing (by slowly buying small amounts of stock or bonds over a longer period of time and at a set rate) is automatically set in motion by participating in a 401K plan.
A 401K plan allows the employee to systematically put away a portion of her paycheck, tax-free, for retirement investment. Contributions keep pace with the employee paycheck schedule, and thus spread the investment purchases over time and keep them consistent. Your employer’s 401k plan defines the maximum contributions that the employee can make as well as any matching contributions from the employer. The terminating employee then receives the proceeds either in a current or deferred lump sum or annuity. Penalties are payed if the money is taken out before a certain age since the 401k program was instantiated to spur retirement savings.
Employee contributions to their 401K plan are automatically deducted from their paycheck each period. The money is taken out even before the employee’s paycheck is taxed as an incentive for retirment investing. The contributions are then invested at the employee’s direction into one or more funds or stocks that are provided in the plan. Employers can match the employee contributions but they are not required to do so.
Given the way 401k plans work, by taking money out of paychecks, they naturally employ a dollar cost averaging strategy, inheriting all of its benefits such as protection against volatility and taking advantages of market swings. Making a commitment to invest is already taken care of because the deductions are automatically made for you. There is little room for temptation or to funnel the money into other things (you should never borrow against your 401k). Since the contribution is invested into a fund or funds of the employee’s choosing, she can determine which investment options are better for the type of exposure that she wants to commit for her plan. Thirdly, if the employee works in a company wherein it is policy for the employer to match the employee’s contribution, not participating in the 401k is like giving away money, and no one wants to do that. Company contribution allows the employee to know that by committing a certain amount every month to her 401k, she’ll instantly be rewarded by getting something very much like an extra bonus from the company.
In sum, by invesitng in your 401k or other retirement plan, you can receive all the benefits of an intelligent investment method that takes very little work on your part: Dollar Cost Averaging.