How to Calculate Rolling Returns

How to Calculate Rolling Returns – SmartAsset

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When comparing investments in your portfolio, you may be concerned primarily with the returns a particular security generates over time. Rolling returns measure average annualized returns over a specific time period and they can be helpful for gauging an investment’s historical performance. Knowing how to calculate rolling returns and interpret those calculations is important when using them to choose investments. A financial advisor can familiarize you with several other metrics to gauge your investments’ progress.

What Are Rolling Returns?

Rolling returns represent the average annualized return of an investment for a given time frame. Specifically, rolling return calculations measure how a stock, mutual fund or other security performs each day, week or month from the time frame’s beginning to ending dates.

Essentially, rolling returns breaks a security’s performance track record into blocks. Investors can determine what return data to focus on for a particular block of time. For example, you may use rolling returns to measure a stock’s monthly performance over a five-year period or its daily returns for a three-year period.

Rolling returns calculations can measure an investment’s return from dividends and price appreciation. Typically, it’s more common to use longer periods of time such as three, five or even 10 years, to measure rolling returns versus to get a sense of how an investment performs. That’s different from annual return, which simply measures the return a security generates within a given 12-month period. It’s also different from yield.

How to Calculate Rolling Returns

If you’re interested in using rolling returns to evaluate different investments, there’s a step-by-step process you can follow to calculate them. The first step is choosing a start date and end date for which to measure returns. For example, say you want to measure rolling returns for a particular stock over a 10-year period. If you’re specifically interested in how well the stock performs in recessionary environments, you might set the tracking to extend from Jan. 1, 2006, to Jan. 1, 2016, which would include performance history for the Great Recession.

The next step is determining the return percentage generated for each year of the period you’re tracking. To do this, you’ll need to know the starting price and ending price for the stock or other security for the applicable years. Take the ending price and subtract the beginning price, then divide that amount by the beginning price to find that year’s return.

Next, you’ll use averaging to calculate rolling returns. Add up the return percentages you calculated for each year of the time period you’re tracking. Then divide the total by the number of years to get the average annualized return.

To find rolling returns, you’d simply adjust the time frame being measured. So, if you started with Jan. 1, 2006, for example, you could adjust your time frame to track the period from Feb. 1, 2006 to Feb. 1, 2016. Or you could look at rolling returns on a yearly basis, which means removing returns for 2006 and recalculating using returns for 2017.

This makes it fairly easy to customize rolling returns calculations when evaluating investments. You could use rolling returns calculations to mimic your typical holding period for a stock or mutual fund. For example, if you normally hold individual investments for five years then you might be interested in isolating rolling returns for that same time frame.

Rolling Returns vs. Trailing Returns

When comparing investments, you may also see trailing returns mentioned but they aren’t the same as rolling returns. Trailing returns represent returns generated over a given time period, e.g. one year, five years, 10 years, etc. For that reason, they’re often called point-to-point returns.

Trailing returns can be helpful if you’re interested in getting a snapshot look at an investment’s performance history. That’s useful if you want to know exactly how an investment performed at any given time. Trailing returns can be problematic, however, since it’s difficult to use them to gauge how an investment might perform in the future.

What Rolling Returns Tell Investors

Rolling returns can be useful for comparing investments because they can offer a comprehensive view of performance and returns. Specifically, examining rolling returns rather than focusing solely on annual returns allows you to pinpoint the periods when an investment had its best and worst performance. For example, you could use a five-year rolling return to determine the best five years or the worst five years a particular stock or fund offered to investors. This can help with deciding whether an investment is right for your portfolio, based on your goals, risk tolerance and time horizon for investing.

If you lean toward long-term buy-and-hold strategies versus shorter-term day-trading, for instance, then rolling returns can give you a better idea of how well an investment may pay off while you own it. Looking only at average annual returns may skew your perception of an investment’s performance history and what it’s likely to do in the future.

You may use rolling returns as part of an index investing strategy. Index investing focuses on matching the performance of a stock market benchmark, such as the S&P 500 or the Nasdaq Composite. It’s possible to calculate rolling returns for a stock index in its entirety, which can make it easier to see where the high and low points are for performance.

If you prefer actively managed funds in lieu of index funds, calculating rolling returns can also be helpful. In addition to assessing the fund’s performance over a specified time frame, rolling returns can also offer insight into the fund manager’s skill and expertise. If, for example, an actively managed fund outperforms expectations during an extended period of market volatility that can be a mark in favor of the fund manager’s strategy.

The Bottom Line

Rolling returns can make it easier to set your expectations for a particular investment, based on its best and worst historical performance. Calculating rolling returns isn’t difficult to do, and it’s something to consider if you’re focused on the long-term with your investment strategy.

Tips for Investing

  • An investment calculator can give you a quick estimate of how your investments will be doing in the years to come. Just put in the starting balance, yearly contribution, estimated rate of growth and time horizon.
  • Consider talking to your financial advisor about rolling returns and how to calculate them. If you don’t have a financial advisor yet, finding one doesn’t have to be difficult. SmartAsset’s financial advisor matching tool makes it easy to connect with professional advisors locally. If you’re ready, get started now.

Photo credit: ©, ©, © Prasertthai

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She’s worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.

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Ergodicity: The Coolest Idea You’ve Never Heard Of – The Best Interest

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Surely that’s a typo…ergodicity!? No, it’s right! Ergodicity is a powerful concept in economic theory, investing, and personal finance.

Even if the name seems wild to you, the idea is simple—stick with me while I explain it. And then we’ll apply ergodicity to retirement planning and investing ideas.

By the end of this article, you’re going to be seeing ergodic systems and non-ergodic systems all over your life!

Ergodic, Non-Ergodic, and Russian Roulette

Ergodicity compares the time average of a system against the expected value of that system. Let’s explain those two terms: time average and expected value.

The time average asks, “If we did something a million, billion, trillion times…what would we expect the results to look like?” It needs to be a sufficiently long random sample.

The expected value asks, “By simply averaging probabilities, where would we expect the result to be?”

At first blush, you might think, “Those two are the same thing…right?” Right! Or, at least you’d be right if the system in question is ergodic.

I flip a coin a billion times, and I end up with a time average of 50/50 heads and tails. Alternatively, I could just use their known probabilities and surmise the expected value of 50/50.

In this case, the time average and the expected value are the same. Therefore, the system—coin flipping—is ergodic.

But let’s contrast coin flips against Russian Roulette. The expected value of Russian Roulette is optimistic. ~83% success and ~17% failure. But what happens if one “plays” a million times? Ahh! I think you’d agree that the time average of Russian Roulette is 100% failure.

When one fails in Russian Roulette, it is a devastating failure. To only look at the expected value of the system is too simple. The expected value is far different than the time average. Thus, Russian Roulette is non-ergodic.

Ergodicity –> Over and Over, Big & Small

Ergodicity rears its head in two circumstances. First, ergodicity matters when we do things over and over and over. And second, ergodicity matters when certain outcomes are meaningful while other outcomes are insignificant.

To further explain ergodicity, imagine this bet:

I have a 100-sided die.

I’ll roll the die and you pick a number. If it lands on any other number than your number, then you win $1000.

But if it lands on your number, then Mike Tyson punches you in the face and takes your money.

What a deal! You call 99 of your friends and you all come to take this bet. Sure enough, one of your friends loses. But the rest of you win a combined $99,000 and agree to pay for his medical bills (which may or may not be covered by the $99K…which is another crazy blog post waiting to happen).

The “ensemble average” is that you won! One individual loss doesn’t change that.

But would that result be the same if you had played 100 times by yourself? No! In that scenario, there’s a 63% chance that you’d eventually lose the roll, lose your money, and get punched in the face.

The expected value (you and all your friends) is different than the time average (you doing it 100x). This is not an ergodic process.

Revisiting Ergodicity & Coin Flips

We concluded earlier that coin flips are ergodic. The expected value of a single coin flip equals the time average results of many coin flips.

But let’s change the rules a bit. Imagine I promised you a 40% positive return on heads but a 30% loss on tails. You start with $100,000. Would you take this bet?

Again, let’s call up 100 of your friends. You each take the bet.

We can predict that half of you will end up with $140K (40% return) and half end up with $70K (a 30% loss). On average, you each have $105K. As a group, you’ll end up 5% higher than you started.

Sure enough, we can run this simulation a million times and that’s exactly what we see. Both the mean and median results of these simulation show a 5% profit. Taking the bet was smart.

But what if you took the bet 100 times? Same result?

Same for You?

To start, let’s look at two common snippets in the sequence of returns: one win followed by one loss, and one loss followed by one win.

Win then loss

Loss then win

(You mathematicians will see the commutative property at play. The order of this multiplication didn’t matter.)

This result completely shifts our mindset.

When two people share a win/loss, then end up with $140K+$70K = $210K, or $105K each. They gain $5K. But when one person sequentially suffers a win/loss, she ends up with $98K, or a $2K loss.

What happens if you take this bet 100 times in a row? On average, you are going to lose money. Let’s look at a 50/50 heads/tails split.

Group 50/50:

That’s a 5% profit.

You 50/50:

That’s a 64% loss

But you might “spike” a certain run where you get more heads than tails. What happens if the group gets 60 heads and 40 tails? What happens if you get 60 heads and 40 tails?

Group 60/40:

You 60/40:

That’s…a big profit. $37.3 million.

I simulated the “you get 100 flips” case 100,000 times. As expected, the median result is a 64% loss. But the best result of the 100K simulations turns your $100K bet into $950 million dollars (68 heads, 32 tails).

This bet is non-ergodic. The expected value (100 friends scenario) is completely different than the time average (you 100x bets scenario).

But it’s also interesting that the distribution in the expected value case is tight (low risk, low reward) while the distribution in the time average case is extremely wide (high risk, potentially high reward).

EV is a profit, while time average is a loss. EV is low variance, while time average is high variance.

In case you can’t tell, ergodicity economics and subsequent economic theory is a serious field. There are big conversations taking place and serious money to be made (or lost).

But let’s focus a little closer to home: ergodicity and retirement.

Ergodicity and Retirement

In retirement planning, probability of success is often used as a figure of merit. I’ve used it here on the blog.

For example, the famous Trinity Study and 4% Rule cite a “95% chance of success,” where success is equivalent to “not running out of money before you die.”

Die with money? Success! Die without money? Failure! This is an expected value metric—for 95% of all people, the 4% rule would have worked.

But a few problems in this thinking immediately arise and ergodicity is to blame.

Problem 1: Equal and Opposite?

The 5% of retirement fail cases are painful. Very painful. I would argue that the pain of failure in retirement is greater than the joy of success.

This is reminiscent of loss aversion, or the “tendency to prefer avoiding losses to acquiring equivalent gains.” The keyword in loss aversion is “equivalent.” People would rather avoid a $100 parking ticket than win a $100 lotto ticket. Those are equivalent. And yes, loss aversion is irrational.

But is failing in retirement equivalent-and-opposite to succeeding in retirement? I’d argue no. Failing in retirement is akin to a Russian Roulette loss. Devastating! And succeeding in retirement is a Russian Roulette win. It’s “expected.”

Problem 2: Expected Value & Risk Sharing

Let’s assume we all follow the 4% rule. And true to historical form, let’s assume that 95% of us have successful retirements, but 5% of us “fail” and run out of money.

In the previous examples—100 friends and Mike Tyson, or 100 friends and the 40% win/30% loss coin flip—we assumed that the group would share the risk and share the reward.

This guaranteed that we’d see profits, but eliminated our chance to win $950 million. This guaranteed that even if we did get face-punched by Mike Tyson, our winning friends would still help us out.

But in retirement planning, people do not share risk. The 95% winners have no obligation to bail out the 5% losers. This changes the game. This isn’t traditional ergodicity.

Instead, we’re all in the game by ourselves (like the time average participant), but only have one shot to get it right (lest our retirement plan fail). From the ergodicity point of view, it’s a conundrum. It’s like playing Russian Roulette with a 20-chamber gun (5% failure = 1 chance in 20).

How do potential retirees react to this change in the rules?

For starters, many real retirement plans are couched with so much conservatism that the retiree ends up with more money when they die than when they retired. Put another way—their investment gains outpace their ability to spend.

And we know that money is time. Therefore, we can conclude that many people work for years more than they need to. They’re cursing at spreadsheets when they could be sipping mojitos. Pardon my 2020 vernacular, but this is an abundance of caution.

Is there an ergodic solution to this over-cautious planning?

Does Ergodicity Have a Solution?

What did we learn from Mike Tyson ergodicity example? What did we learn from our coin flipping?

If we share risk, we reduce our potential upside but also eliminate downside.

Imagine that 100 retirees pool a portion of their money together. They all know that 95% of them won’t need to dip into that pool. They also know that their money in the pool is probably going to have worse returns than it would outside of that pool.

However! These 100 retirees also realize that the pool will save 5 of them from failure. And thus, the pool guarantees that their retirement will be successful. Instead of 100% of them worrying about a 5% downside, now none of them need to be concerned.

The purpose of investing is not to simply optimise returns and make yourself rich. The purpose is not to die poor.

William Bernstein

Some of you will know that this “pool” concept already exists. It’s called an annuity.

Annuities?! Jesse, You Son of a B…

Wait, wait, don’t shoot me! Besides, you only have one bullet in those 20 chambers (thank ergodicity)

Real quick: an annuity is a financial product where a customer pays a lump sum upfront in return for a series of payments over the rest of their life. Insurance companies often sell annuities.

Annuities—on average—are losing propositions. Just like my pool above, the average annuitant will suffer via opportunity costs. Their money—on average—is better invested elsewhere.

Insurance protects wealth. It doesn’t build wealth.

Ben Carlson

Never let someone convince you that an insurance product is going to build your wealth. Why? There are only two parties involved—you and the insurance company. If you’re building wealth, then the insurance company is…losing money? No way.

Insurance products are equivalent to average mutual funs with high fees. The high fees drain you like a vampire bat. They make money, and you lose via opportunity costs.

But one thing that annuities get right is that they hedge against downside risk in your retirement planning. The insurance company—i.e. my pool in the example above—collects a loss from most customers in order to provide a vital win to few customers.

This is just like real insurance. Most people pay more in insurance premiums—for their house, their car, their medical life—then they ever see in payouts. But for a vital few, insurance saves them from complete disaster.

Of course, detractors will rightly point out that annuities aren’t always guaranteed. If the insurance company goes belly-up, your state guarantor might only cover a portion of what you’re owed. Yes—that means your risk mitigation technique has risk itself. Riskception.

Annuities aren’t perfect. I don’t plan on buying one. But if the ergodicity of retirement planning has you fretting small chances of failure, annuities are one way to hedge that downside.

Is Robin Hood Ergodic?

Jesse is a boring index fund investor. It’s true.

But not Robin. She day-trades on Robin Hood, often experimenting with exotic trades with high leverage.

We can examine Jesse and Robin using ergodicity.

Jesse is playing the long game. In this simple hypothetical, his yearly returns are +30%, +10%, then -15%. The same three-year cycle keeps repeating. One might look at those three values and think, “Ah. About 8.3% per year, on average.”

Robin thinks daily. She wants money now. In this hypothetical, her daily returns are +60%, +15%, and -50%. The same three-day cycle keeps repeating. Again, one might look at those three values and think, “Ah. About 8.3% per day, on average.”

You might see a problem. We’ve used the arithmetic mean here. The arithmetic mean is useful in finding the expected value, in ergodicity terms. If Person A gains 60%, Person B gains 15%, and Person C loses 50%, their average change is an 8% gain.

But sequencing investment returns—e.g. the ergodicity time average—requires that we use a logarithmic average. So let’s do that below:

[note: exp = the exponential function, ln = the natural log]

Uh oh. Robin’s log average return is negative. And sure enough, if Robin executed this particular day-trading strategy, she would turn her $10,000 into $500 in less than four months. Meanwhile, Jesse is fine with his 6.7% annual return (trust me…he is).

The simple lesson is one that new investors love to scream from the rooftops (and that’s a good thing). Namely, a given portfolio loss requires a larger equivalent gain to return back to even. The arithmetic mean does not capture this fact, while the log mean does.

The larger the loss, the more significant the returning gain needs to be. That’s another ergodicity concept.

E.g. a 1% loss is offset by a 1.01% gain—they’re essentially the same. But a 50% loss—like the one Robin suffers every third day—requires a 100% gain to offset it

Just like we said earlier in the post—big risks matter most, and those large downsides are when we’re likely to see non-ergodic systems.

Everyday Ergodicity

I would argue that a smooth, ergodic personal life is also optimal. Imagine ranking your days on a scale of 1-10. Would you rather have half 10’s and half 4s? Or all dependable 7’s? Or two-thirds 10’s and one-third 1’s?

To each their own. I’d prefer the 7’s. I don’t want half my days to be “bad,” even if the flip side of that coin is that half my days are “perfect.”

Don’t make ‘perfect’ the enemy of good enough.

-Someone at Jesse’ work

Maybe it’s boring. Maybe it’s the same muscle that pushes me towards indexing and away from Gamestop. To each their own. But I’ll take the 7’s.

Ergodicity in Grad School

In grad school, I studied fluid dynamics. See—this is me! Specifically, I worked on reaction-diffusion-advection problems in the University of Rochester Mixing Lab.

Fluid mixing is a terrific example of ergodicity. Take a few seconds to watch the video below. It’s a pretty way to view equilibrium statistic physics. Ergodicity applies to many different dynamical systems, stochastic processes, thermodynamic equilibrium problems, etc. It’s a mechanical engineer’s dream.

Ergodic mixing

If we mix sufficiently, we see that small sub-sections of the fluid are representative of the fluid as a whole. The time average of many mixes is equal to our expected value of a uniform mix. This is ergodicity. This system is ergodic.

If this was butter and sugar—soon to be cookies—we could take any teaspoon of the mixture and draw reasonable assumptions about the mixture as a whole. Mmmmm!

But imagine if we accidentally introduce a dog hair into the mix (not that that’s ever happened in my kitchen). Suddenly, the mix is no longer ergodic.

Why? The expected value of any given cookie is that it will not contain the dog hair. But of course, eat enough of the cookies and you’ll eventually find the hair.

Or put another way, a single teaspoon of the mixture—which will contain either the entire dog hair or no dog hair at all—is no longer representative of the total mixture.

Good Article. Ergo…

Ergo it’s time for the summary.

Ergodicity is a fun concept. Or at least fun for nerds like me. It’s a terrific way to consider risk. It helps us in behavioral economics, personal finance, and real retirement planning.

What do you think? Any cool ergodic or non-ergodic systems in your life?

If you enjoyed this article and want to read more, I’d suggest checking out my Archive or Subscribing to get future articles emailed to your inbox.

This article—just like every other—is supported by readers like you.

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Should I Move the Money in My 401(k) to Bonds?

Should I Move the Money in My 401(k) to Bonds? – SmartAsset

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An employer-sponsored 401(k) plan may be an important part of your financial plan for retirement. Between tax-deferred growth, tax-deductible contributions and the opportunity to take advantage of employer matching contributions, a 401(k) can be a useful tool for investing long term. Managing those investments wisely means keeping an eye on market movements. When a bear market sets in, you may be tempted to make a flight to safety with bonds or other conservative investments. If you’re asking yourself, “Should I move my 401(k) to bonds?” consider the potential pros and cons of making such a move. Also, consider talking with a financial advisor about what the wisest move in your portfolio would be.

Bonds and the Bear Market

Bear markets are characterized by a 20% or more decline in stock prices. There are different factors that can trigger a bear market, but generally they’re typically preceded by economic uncertainty or a slowdown in economic activity. For example, the most recent sustained bear market lasted from 2007 to 2009 as the U.S. economy experienced a financial crisis and subsequent recession.

During a bear market environment, bonds are typically viewed as safe investments. That’s because when stock prices fall, bond prices tend to rise. When a bear market goes hand in hand with a recession, it’s typical to see bond prices increasing and yields falling just before the recession reaches its deepest point. Bond prices also move in relation to interest rates, so if rates fall as they often do in a recession, then bond prices rise.

While bonds and bond funds are not 100% risk-free investments, they can generally offer more stability to investors during periods of market volatility. Shifting more of a portfolio’s allocation to bonds and cash investments may offer a sense of security for investors who are heavily invested in stocks when a period of extended volatility sets in.

Should I Move My 401(k) to Bonds?

Whether it makes sense to move assets in your 401(k) away from mutual funds, target-date funds or exchange-traded funds (ETF) and toward bonds can depend on several factors. Specifically, those include:

  • Years left to retirement (time horizon)
  • Risk tolerance
  • Total 401(k) asset allocation
  • 401(k) balance
  • Where else you’ve invested money
  • How long you expect a stock market downturn to last

First, consider your age. Generally, the younger you are, the more risk you can afford to take with your 401(k) or other investments. That’s because you have a longer window of time to recover from downturns, including bear markets, recessions or even market corrections.

If you’re still in your 20s, 30s or even 40s, a shift toward bonds and away from stocks may be premature. The more time you keep your money in growth investments, such as stocks, the more wealth you may be able to build leading up to retirement. Given that the average bear market since World War II has lasted 14 months, moving assets in your 401(k) to bonds could actually cost you money if stock prices rebound relatively quickly.

On the other hand, if you’re in your 50s or early 60s then you may already have begun the move to bonds in your 401(k). That might be natural as you lean more toward income-producing investments, such as bonds, versus growth-focused ones.

It’s also important to look at the bigger financial picture in terms of where else you have money invested. Diversification matters for managing risk in your portfolio and before switching to bonds in your 401(k), it’s helpful to review what you’ve invested in your IRA or a taxable brokerage account. It’s possible that you may already have bond holdings elsewhere that could help to balance out any losses triggered by a bear market.

There are various rules of thumb you can use to determine your ideal asset allocation. The 60/40 rule, for example, dictates having 60% of your portfolio in stocks and 40% dedicated to bonds. Or you may use the rule of 100 or 120 instead, which advocate subtracting your age from 100 or 120. So, if you’re 30 years old and use the rule of 120, you’d keep 90% of your portfolio in stocks and the rest in bonds or other safer investments.

Consider Bond Funds

Bond mutual funds and bond ETFs could be a more attractive option than traditional bond investments if you’re worried about bear market impacts on your portfolio. With bond ETFs, for example, you can own a collection of bonds in a single basket that trades on an exchange just like a stock. This could allow you to buy in low during periods of volatility and benefit from price appreciation as you ride the market back up. Sinking money into individual bonds during a bear market or recession, on the other hand, can lock you in when it comes to bond prices and yields.

If you’re weighing individual bonds, remember that they aren’t all alike and the way one bond reacts to a bear market may be different than another. Treasury-Inflation Protected Securities or TIPS, for example, might sound good in a bear market since they offer some protection against inflationary impacts but they may not perform as well as U.S. Treasurys. And shorter-term bonds may fare better than long-term bonds.

How to Manage Your 401(k) in a Bear Market

When a bear market sets in, the worst thing you can do is hit the panic button on your 401(k). While it may be disheartening to see your account value decreasing as stock prices drop, that’s not necessarily a reason to overhaul your asset allocation.

Instead, look at which investments are continuing to perform well, if any. And consider how much of a decline you’re seeing in your investments overall. Look closely at how much of your 401(k) you have invested in your own company’s stock, as this could be a potential trouble spot if your company takes a financial hit as the result of a downturn.

Continue making contributions to your 401(k), at least at the minimum level to receive your employer’s full company match. If you can afford to do so, you may also consider increasing your contribution rate. This could allow you to max out your annual contribution limit while purchasing new investments at a discount when the market is down. Rebalance your investments in your 401(k) as needed to stay aligned with your financial goals, risk tolerance and timeline for retiring.

The Bottom Line

Moving 401(k) assets into bonds could make sense if you’re closer to retirement age or you’re generally a more conservative investor overall. But doing so could potentially cost you growth in your portfolio over time. Talking to your 401(k) plan administrator or your financial advisor can help you decide the best way to weather a bear market or economic slowdown while preserving retirement assets.

Tips for Investing

  • It’s helpful to review your 401(k) at least once per year to see how your investments are performing and whether you’re still on track to reach your retirement goals. If you notice that you’re getting overweighted in a particular asset class or stock market sector, for example, you may need to rebalance to get back on track. You should also review the fees you’re paying for your 401(k), including individual expense ratios for each mutual fund or ETF you own.
  • Consider talking to a professional financial advisor about the best strategies to implement when investing in bear markets and bull markets as well. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s financial advisor matching tool makes it easy to connect with professional advisors online. It takes just a few minutes to get your personalized advisor recommendations. If you’re ready, get started now.

Photo credit: ©, © Kavaleuskaya, ©

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She’s worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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Alternatives to 401(k)s: Other Routes to Retirement – The Best Interest

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Today, guest author Jeff Cooper of Have Your Dollars Make Sense offers interesting views on alternatives to 401(k) accounts. I maximize my 401(k) with my investment strategy, but I enjoyed understanding Jeff’s ideas.

Thanks Jeff!

-Jesse from The Best Interest

For most of us, a 401(k) is our main approach to saving for retirement. The concept is easy—stash away money now and use it later. But there are alternatives to 401(k) accounts…and for good reason!

Many people take pride in saying “I max out my 401(k)”, with the assumption they are taking the best possible route to retirement. But are they?

The two main objectives of investing are diversifying assets to lower risk while still maximizing returns.  401(k) accounts don’t check both of these boxes all of the time. They are a great tool for retirement planning but shouldn’t be your only tool.

So let’s look at alternatives to 401(k) accounts that will make your money work best for you and your retirement goals.   

401(k): Why You Should Contribute  

I’m not suggesting you completely ignore your 401(k). There are good reasons why you should be contributing. To name a few…

Company Matching

Many companies that offer 401(k) accounts will also match a percentage of an individual’s contribution. In the eyes of the employee, this is literally free money. There really is no reason not to take advantage of this benefit. Avoid any alternatives to 401(k)s that neglect this free money.

You should, however, be aware of how much your employer will match. Many employers cap the matching around 4-6% of your salary. After that, only your dollars will count towards your nest egg.

I also recommend looking into your company’s vesting schedule to understand when you’ll get partial- and full-ownership of the company matches.

Some companies will “clawback” their matching funds if you leave before a predetermined amount of time. You should, however, still be entitled to your full individual contributions. You’ll have to determine if you plan on being at your company long enough to take full advantage of their matching.     

Maximize Pre-Tax Dollars

Another money-saving advantage of a 401(k) is that your money is invested before taxes are taken out. This means you’ll get more bang for your buck, and here’s why:

If you wait to invest your post-tax dollars, there’s less money available to invest. For example, let’s say Jesse loses $50 per month due to taxes. It might not seem like a big deal. Just $50 a month!

But that $50 deficit will add up over the years. $50/month * 30 years = $18,000!

On top of that, the power of compounding gains on those missed dollars could be a difference of tens of thousands of dollars by the time retirement rolls around. The example below shows how Jesse might miss out on $40,000+ in compounding returns.

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Lower Taxable Income

Contributing pre-tax dollars to your 401(k) will also help to lower your taxable income. Few alternatives to 401(k) accounts can mimic this benefit.

Let’s say you have a salary of $100,000 per year.

If you contribute 8% of your salary, not only are you investing $8,000 of untaxed earnings but now Uncle Sam will only consider the remaining $92,000 to be taxable. It’s a rare win-win situation for the little guy when it comes to tax season.

Alternatives to 401(k): Customize Your Investment Strategy

There are definitely advantages to contributing to a 401(k), and it’s easy to understand why it remains one of the most popular investing options. But it’s also important to take a step back to think about what you’re ultimately trying to accomplish.

Here are some alternative ways to invest in your financial future (both short- and long-term) that may be better suited for you and your retirement goals. Let’s step through these alternatives to 401(k) accounts one by one.

Assess Current Financial Obligations

Retirement should be one of your top financial priorities once you enter the workforce, but that doesn’t mean you need to throw every last penny towards it right away.

In the beginning, contribute what you can while still maintaining current financial responsibilities.  Once you start to build up a solid financial foundation, you can begin to increase your contribution accordingly.

Another top priority is that emergency fund. Ideally, everyone should aim to have four to six months’ worth of expenses stashed away somewhere nice and safe. If you don’t have that money set aside, then putting less into the 401(k) and more into your savings may be more beneficial. 

Debt is also a big factor to consider when determining your contribution.  For as much as compounding gains can help you, compounding interest payments can be devastating. The interest rate on debt is typically guaranteed, but the rate on your investing gains often isn’t.

While you don’t need to wait until you are 100% debt-free before investing, you do need to be able to comfortably make all debt payments (and preferably extra) before amping up your 401(k) contributions.

Don’t Limit Yourself

Remember that diversity objective? Well, in my opinion, you can’t get a truly diversified portfolio in a 401(k).

Most companies provide a basket of 20-30 different mutual funds to choose from, and that’s all you get. Yes, by nature mutual funds will give you some degree of diversity. But you can’t reach the same levels that a traditional investment account can offer.

Plus, I wouldn’t want someone telling me what I can and can’t invest in. It’s my future! Alternatives to 401(k) accounts can open more doors.

And here’s a heads-up: mutual funds charge fees for managing your money—often called the expense ratio. Make sure to look for funds with low expense ratios. Index funds are typically the lowest.   

Index Funds fees can be significantly lower

Alternative Investments Can Potentially Offer Higher Returns 

Buying individual stocks isn’t typically available through 401(k) accounts. But historically, stocks have much higher returns than bond-laden mutual funds. Plus, there are no management fees when you pick your own stocks! You buy them at a fixed price and that’s that.

Yes, there’s a higher risk involved with hand-picking stocks. But the objective here is to grow your money as much as possible. If your risk tolerance is low, then you may want to stick with mutual funds. 

For those who are willing to roll the dice on alternatives to 401(k) funds, stocks are the way to go. Investing in stocks while still contributing to 401(k) mutual funds can both increase your returns and diversify your portfolio.

Investing isn’t limited to the stock market either. In today’s world, there are tons of different investment opportunities. Money can be invested in ways that weren’t always available to individual investors in the past. There are sites that let you invest in startups, cryptocurrency, online REITs, and the list goes on.

Each alternative to 401(k)s comes with a unique riskreward profile. But again, it’s all about diversifying and maximizing those returns. If you’re younger and can afford to take risks, then the choice is yours.

401(k)s don’t typically provide the opportunity to make these kinds of higher risk, higher reward investments.

Use Alternatives to 401(k)s to Align Overall Retirement Goals

Most people just assume they’ll work until they’re 55, 60, or 65 years old and use the 4% Rule. But that’s not for everyone—I know I don’t plan on it!

If you’re looking forward to an early retirement like I am, you’ll need access to your money. This may be a problem if most of your investments went into your 401(k), as you can’t begin to make penalty-free withdrawals until the age of 59½. The money will be sitting right there, but you can’t touch it without getting slapped. 

Having a well-diversified and accessible investment portfolio will allow you to retire when YOU decide you can. 


401(k) accounts have their advantages and deserve a place in your retirement portfolio. They offer several tax benefits and might give you free money, making it a no-brainer to contribute to them right away.

But you shouldn’t overlook the other options out there. There are alternatives to 401(k) accounts that have lower fees and higher returns. The money saved from fees and gained from higher returns could potentially outweigh the taxes you might save. It’s a big balancing act.

But remember: whatever you decide to invest in, it’s bringing you closer to your retirement goals and financial freedom!

Thanks again to Jeff Cooper of Have Your Dollars Make Sense for today’s article.

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Tagged 401(k), guest post, retirement


What’s the Difference Between a Traditional and Roth 401(k)?

If you work for a company that offers a retirement plan you might be confused about making traditional or Roth contributions. Laura reviews the critical differences to consider and how they affect your current taxes and future retirement.


Laura Adams, MBA
February 17, 2021

retirement plan, such as a 401(k) or 403(b), you probably have the option of making “traditional” or “Roth” contributions to your account. While having more investment options is a good thing, it might leave you feeling overwhelmed or confused about the benefits of each. 

Today, I’ll review critical points about the differences between a traditional and Roth retirement plan at work. You’ll learn who qualifies to participate, how much you can contribute, and how they affect your retirement and taxes.

What is a 401(k) retirement plan?

Only employers can offer a traditional or Roth 401(k) or 403(b) to eligible workers. You may have to reach a certain age, such as 21, or be employed for a period, such as one or six months, to qualify. 

Employers can customize certain features of their retirement plans; however, they must comply with the Employee Retirement Income Security Act of 1974 (ERISA). It’s a federal law that sets minimum standards for most workplace retirement plans, which protects participants. Your employer should provide a Summary Plan Description every year, which explains your retirement plan’s features and your rights.

There aren’t many ways to save for retirement that guarantee a 100% return before you even factor in investment returns!

When you enroll in a 401(k), you authorize your employer to automatically deduct elected contributions from your paycheck and send them to your retirement account. If your company offers matching funds, they contribute additional money for free. 

An example of a typical 401(k) match is 2% or 3% of your compensation. For instance, if your salary is $40,000 a year, 2% is $800. If you contribute that much, so will your employer, giving you a total contribution of $1,600 ($800 from your paycheck plus $800 from your company). And if you can only contribute $500, your employer contributes $500, for a total contribution of $1,000 for the year. There aren’t many ways to save for retirement that guarantee a 100% return before you even factor in investment returns! So always be sure to participate in a workplace plan and max out matching funds when offered.

Some retirement plans come with a vesting schedule. It’s a period you must remain employed to fully own your matching contributions or other employer-provided funds, such as profit sharing. However, your contributions are always 100% vested. You never forfeit your own money that you put in a retirement account (unless your chosen investments lose money).

The annual 401(k) and 403(b) contribution limits have been slowly increasing every few years, based on IRS rules. For 2021, you can contribute up to $19,500, or $26,000 if you’re over age 50. The high contribution limits, automatic payroll deductions, and free matching make workplace retirement plans popular and useful for growing wealth to spend in retirement.

Differences between traditional and Roth retirement accounts

Now that you understand retirement account basics let’s cover the differences between traditional and Roth accounts.

traditional retirement account permits pre-tax contributions, which gives you a tax benefit in the year you make them. You don’t pay any income tax on the money you invest. Instead, you pay income tax on your contributions and their investment earnings when you take withdrawals in retirement. 

Roth retirement account requires you to make after-tax contributions, which don’t give you an upfront tax benefit. However, the massive upside is that you take withdrawals of both contributions and earnings that are entirely tax-free in retirement (as long as you’ve owned the account for at least five years).

The downside of any retirement account is that you get penalized for tapping amounts that weren’t previously taxed before reaching the official retirement age of 59.5.

So, the main difference between traditional and Roth accounts is when you pay taxes. A traditional retirement account helps cut your current income tax bill. And a Roth allows you to avoid income tax when you tap the account in the future.

With a Roth, you’re allowed to withdraw your contributions at any time. That’s because you already paid tax on them. However, if you take out earnings before age 59.5, you must pay a 10% penalty, plus income tax, on the untaxed portion.

The downside of any retirement account is that you get penalized for tapping amounts that weren’t previously taxed before reaching the official retirement age of 59.5.

5 ways a workplace Roth is different from a Roth IRA

Many people mistakenly assume that a Roth is a Roth. It’s important to understand five main differences between a Roth 401(k) and a Roth IRA.

1.  Limits on annual income apply to a Roth IRA but not a Roth at work. When your income exceeds yearly limits, you can’t make new contributions to a Roth IRA. For 2021, single taxpayers with income exceeding $140,000 and joint filers with household income over $208,000 get locked out. However, with a Roth 401(k) or 403(b), you can contribute no matter how much you earn.   

2. Annual contribution limits for a Roth IRA are much lower than a workplace Roth. For 2021, you can contribute up to $6,000, or $7,000 if you’re over age 50, to all your IRAs. As I previously mentioned, you can contribute a total of up to $19,500, or $26,000 if you’re over 50, to your workplace retirement accounts.

3. Required minimum distributions (RMDs) don’t apply to a Roth IRA. You can keep money in the account indefinitely and pass it along to your heirs. But you must take RMDs from a Roth at work no later than age 72 (unless you’re still employed there). As long as you’ve owned the account for five years, your distributions will be tax-free.

4. Early withdrawals of Roth IRA contributions can be made at any time without triggering income taxes or a penalty. However, taking withdrawals from a Roth at work typically come with conditions, such as experiencing a financial hardship like unpaid medical bills or funeral expenses.

5. Loans are typically permitted for a Roth at work. You must pay your account back with interest on a five-year schedule. However, taking a loan from a Roth IRA isn’t allowed.

So, you can see that a Roth 401(k) and a Roth IRA have similar advantages and have differences in how participants can use them.

RELATED: What Is a Backdoor Roth IRA?

Should you choose a traditional or Roth retirement account?

A significant factor in choosing a traditional or a Roth retirement account is the income tax rates in the future and how much you’ll make during retirement. None of us can predict the future, so we have to guess what will be best.

If you prefer a “bird in the hand” to cut taxes sooner rather than later, then a traditional account may appeal to you. But if you don’t mind paying taxes in the current year, then a Roth has more long-term advantages.

If you prefer a “bird in the hand” to cut taxes sooner rather than later, then a traditional account may appeal to you. But if you don’t mind paying taxes in the current year, then a Roth has more long-term advantages. 

When you’re not sure which type to choose, or you want benefits of both types of accounts, you can split contributions between both a Roth and a traditional 401(k) or 403(b) in the same year. You can choose any proportion, such as 50/50 or 20/80, as long as your total doesn’t exceed the allowable annual limit set by the IRS.

If your income is too high for a Roth IRA, having a Roth at work is a terrific benefit. As I mentioned, there are no income limits on a workplace Roth. That means high earners can use one and enjoy tax-free withdrawals in the future.

Having both taxable and non-taxable income in retirement is a good idea. So, instead of deliberating between a traditional or a Roth at work, consider the benefits of using both. If you have employer matching, those contributions are always traditional or pre-tax. So, choosing a Roth 401(k) or 403(b) is an excellent way to diversify your future income and choices.