Back in August, I wrote all about saving and where to put those savings. One of the first places I advised you to save was in your employer-sponsored retirement plan. For most people, that plan is a 401(k). However, you can apply what you'll read in this article to nearly any Defined Contribution Plan[1] your employer may have in place for you.
If you've read any of my other posts, you know that one-size-fits-all advice is not what I'm about. Below I'll be laying out principals and rules of thumb you can use in making choices that fit your specific situation. I am not giving you specific advice on securities to buy, hold or sell.
Things You Need to Know First
Before you can decide what to invest in within your 401(k), you first need to understand risk tolerance and asset allocation. I did a deep dive on Risk Tolerance and why it matters back in May. For our purposes here, I'll tell you that each investor has their own ability to tolerate fluctuations in the value of their investments over time. Aggressive investors can deal with big swings in account value. Conservative investors can't. So, you must first figure out your Risk Tolerance.
Most 401(k) providers have a risk-profiling questionnaire that you can complete to learn what your Risk Tolerance is.
Once you know your Risk Tolerance, you can decide on an asset allocation. When I speak of asset allocation, I'm speaking of how you divvy up your money between stocks, bonds, and cash. Generally, when investing assets for the long term, investors hold no or a very small amount of cash. An aggressive investor may have 80% to 100% of their assets in stocks. A conservative investor may have none or as little as 20% of their assets in stocks. Most investment professionals will advise picking one of the following allocations:
- 0% stocks, 100% bonds / Highly Conservative
- 20% stocks, 80% bonds / Conservative
- 40% stocks, 60% bonds / Moderately Conservative
- 60% stocks, 40% bonds / Moderate
- 80% stocks, 20% bonds / Moderately Aggressive
- 100% stocks, 0% bonds / Aggressive
Once you know how much risk you can take and have decided on the proportion of stock and bonds to own, you need to pick actual investments.
What Are My Options?
A 401(k) plan does have limitations, and one of those limitations is on what you can own. Unlike an IRA or investing account, you can't go out and buy whichever pet stock[2] you like or that mutual fund you read about on the internet. Your plan will have a menu of options from which you can choose.
Your first option is always to leave your money invested in the plan's default investment option. Every plan has one. However, that default investment option may or may not fit your goals or ability to tolerate risk.
For those new to investing, or those who simply don't want to fuss with building a portfolio from the ground up, many plans offer Life Path (also called Target Date) Funds. These are mutual funds that are invested aggressively (taking more risk) when you are far away from your retirement date and invest less aggressively (taking less risk) the closer you get to your retirement date. These are a good solution for novice investors who want a simple investment that gives them access to a professional money manager. The money manager in question is the team of people who manage the Life Path Fund. These funds often have names like "Retirement 2045," "Life Path 2030," or "Target Date 2050" - where the year date is the year you would turn 65. Two major drawbacks of these types of mutual funds:
- They can be expensive, especially if they are funds of funds. A fund of funds is a mutual fund that buys other mutual funds. That's two layers of fees to pay and very little transparency.
- They may not fit your risk tolerance or goals at all times in your investing life. For example, if you are a conservative investor, a life path fund in your 20s may be too risky for you to tolerate. Conversely, if you are an aggressive investor, a life path fund in your 50s may not offer the level of return you desire.
You can always DIY your investments by picking the funds from the menu that fit your ability to tolerate risk. For example, if you are a Moderate investor who wants 60% stocks and 40% bonds, you might consider choosing up to five stock funds and at least two bond funds to own.
Which Fund Is the Best?
"Past performance does not guarantee future results." This isn't just a disclaimer we use to cover our behinds; it's a universal truth that every investor must accept. When choosing funds, look first at cost. Why? Because cost is a factor that can be controlled, unlike future returns. A lower-cost fund means that more of your dollars and more of your return remain invested over time.
Past performance does not guarantee future results.
Once you've considered cost, consider whether the fund fits your goals and risk tolerance. When building a portfolio from the ground up, I like to think of it as a fill-in-the-blank exercise. If I'm a Moderately Aggressive investor, I'll be looking to fill my portfolio with 80% stocks and 20% bonds.
Let's start with stocks. Looking at the funds available, I'll first eliminate the most expensive ones. Looking at what's left I could choose two to four funds that will expose me to a broad swath of different stocks. That might mean choosing a Large Cap fund, a Mid Cap fund, a Small Cap fund, and an International fund. Further, I might divide my 80% stock evenly among these four funds so they each make up 20% of my total portfolio.
Now bonds. Once again, I'll first eliminate the most expensive funds. Then I might choose one or two funds that get me exposure to a broad cross-section of the bond market. If I choose only one fund, it will make up 20% of my total portfolio. If I choose two funds, they each might make up 10% of my portfolio.
Your plan may even have model portfolios to help get you started.
How Often Should I Make Changes?
Do not day trade your 401(k). Resist the urge to tweak and fiddle each month. Messing with your investments too often typically does more harm than good. If you did your homework up front, you should only need to review your 401(k) investments annually or semi-annually at most.
What Is Rebalancing?
Many plans will allow you to set up automatic rebalancing. Rebalancing is the process of bringing your asset allocation back into balance when it drifts. For example, you may start off the year with 60% of your investments in stock but then the stock market may have a big rally where price increase quickly. At the same time, your bonds increased in value but didn't keep pace with your stocks (a natural and expected occurrence). Now you have 65% of your investments in stocks. If you rebalance, you'll sell some of the stocks and use the proceeds to buy bonds so that your asset allocation goes back to 60% stocks. It's nice to have this done automatically, but you can also do this when you review your holdings annually.
For many investors who are saving for retirement for the first time in their lives, the process of setting up that first 401(k) can feel intimidating. But the process is far simpler than you may have thought:
- Figure out your Risk Profile
- Choose your asset allocation
- Pick your funds (Default, LifePath, or DIY)
- Check on your account annually
- Repeat until wealthy
Investors should consider the investment objectives, risks, charges and expenses of any mutual fund carefully before investing. This and other information about the fund can be found in the prospectus or summary prospectus. A prospectus or summary prospectus may be obtained from your financial advisor or the fund website and should be read carefully before investing.
This content is provided for informational and educational purposes only and should not be considered investment advice or recommendations and is not an offer to buy or sell, or a solicitation of an offer to buy or sell, any security or investment, or to participate in any particular trading or investment strategy. This is not a complete analysis of every material fact regarding any company, industry or security. The information has been obtained from sources we consider to be reliable, but cannot guarantee their accuracy.
All investments carry some level of risk, including loss of principal.
Get more investment and financial planning basics
[1] A Defined Contribution Plan is an employer-sponsored retirement plan that does not promise a specific payment on retirement but does allow for a specific amount to be contributed in any given year. Common plan types include 401(k), 403(b), SEP IRA, and SIMPLE IRA plans. In a Defined Contribution Plan, you (the employee) bears the investment risk.
[2] You may have the option to buy company stock. This can be a boon to your retirement savings, but caution is warranted. A full discussion of this topic is beyond the scope of this article, but I'll address this in future posts.