I’m 35 and currently putting 10% of my $50K salary in a 401(k) — but I know nothing about the market. Should I just put everything in the S&P 500?

Investments in the stock market are key for growth in your retirement portfolio. But advice on how best to invest is rampant. How can you ensure proper diversification?

Imagine Charlie, a 35-year-old man who hopes to retire at 67, in time to qualify for the standard Social Security benefit. Charlie is currently making $50,000 per year and investing 10% of his income, plus earning a 100% employer match on up to 4% of his salary. He’s also expecting to get a 2% salary increase annually from now until retirement.

With 32 years to go until his target retirement date, Charlie wants to know if he should put all of his 401(k) contributions into the S&P, since he’s not a super-skilled investor and doesn’t understand the market. Is it a good idea?

Is it a good idea to invest all your money in the S&P 500?

Charlie’s idea to invest all of his money in the S&P 500 isn’t a completely terrible one.

The S&P index tracks the performance of around 500 of the country’s largest companies, and those companies come from all different sectors of the economy. So the fund provides automatic diversification with a single investment purchase.

The S&P has also consistently produced 10% average annual returns for many decades, and it’s recommended by famed investors like Warren Buffett, who suggested average investors put 90% of their money into the S&P, and the remaining 10% into bonds. (1)

S&P index funds also usually have really low fees, so Charlie wouldn’t lose a lot of his money to investment costs if he goes this route.

Since the S&P 500 has consistently produced 10% average annual returns, it’s worth taking a look at how much money Charlie would end up with. Assuming he keeps investing 10% of his salary for the next 32 years, earns that 10% plus his full employer match, and gets that 2% annual raise, he’d end up with $2,601,339.23 invested for his future. This is well above the current estimates of his generation, as Millennials report they will need $1 million for retirement, (2) while today’s would-be retirees estimate they will need $1.46 million to retire comfortably.

If he withdraws 4% of that amount in his first retirement year and makes annual inflation-based adjustments, he will have $104,054 in income yearly from his investments. That’s not a bad nest egg, and it’s a simple approach that doesn’t require Charlie to know a lot about investing.

Downsides to investing only in the stock market

While an S&P fund does provide pretty good diversification, the fact is that this strategy would leave Charlie over-exposed to the stock market. And while the S&P has provided consistent annual returns over the long haul, there may be years when it performs poorly, or provides negative returns. If that happened in the five years leading up to Charlie’s retirement, that could cause problems for his portfolio. He would both lose money at the worst time and would then have to begin withdrawing to supplement his income, thus locking in his losses.

That’s why diversification outside of stocks is critical. Moreover, you should reduce the percentage of your portfolio that is in stocks as you get closer to your retirement time. One common rule of thumb is to subtract your age from 110 and invest only that percentage of your money in the stock market to ensure you don’t take too great a risk of poor market timing.

Charlie could follow this rule, putting all of his equity investments into the S&P, while switching an appropriate percentage of his portfolio into bonds each year so he doesn’t get over-exposed to the market. That’s not a bad strategy.

However, while he’s somewhat diversified with his S&P fund, he’s missing out on investments like real estate or investing in emerging markets where he could potentially earn higher returns. These investments come with both greater risk, and the need to dedicate a lot of research time to the different options, as understanding these markets is critical to making a good bet.

A target date fund could simplify things for Charlie while ensuring he doesn’t put all his eggs in one basket. This type of fund allows you to specify your retirement timeline, and then your investments are divided into a different mix of assets that is appropriate based on when you’ll need to access the invested money.

While target date funds have slightly higher fees than a typical S&P 500 fund, those fees could be well worth paying given the fact that your money is managed across a better spread of assets, and never over-exposed to risk by the wrong asset allocation.

Ultimately, as long as Charlie doesn’t over-expose himself to the market, he can’t really go wrong with exploring both strategies. Though he’s not interested in the market right now, he may choose to educate himself down the line and put together a mix of ETFs on his own, educating himself on the right investment mix. In any case, a financial advisor can help him decide on the best investments for his particular situation, risk tolerance and timeline.

Whatever he chooses, Charlie is smart to question his investment allocations, and he should look to stay the course and keep putting money into his 401(k) until retirement so he can build a secure future.

Article sources

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Investopedia (1); Bankrate (2)

This article provides information only and should not be construed as advice. It is provided without warranty of any kind.