Investments within your 401(k)
Your 401(k) is your tax-advantaged retirement account, sponsored by your employer. You’ve made a smart decision if you participate in your company’s 401(k) plan. But simply putting money into a 401(k) isn’t enough to ensure a comfortable retirement. You must manage your 401(k) portfolio just like you would with any of your other investments. Proper investment management is vital to your future security, whether your 401(k) is one of your many investment
accounts, or your only investment account.
When you enroll in your company’s 401(k) plan, you have a choice in what types of investments your contributions will be put into. Your employer will provide you with a list to choose from, commonly a variety of mutual funds, including a choice of stock funds, some bond funds, a money market fund, and possibly the company’s own stock if they are traded publicly. You may choose to put all your contributions into one investment, or you may choose a mix of investments.
General principles on retirement planning and investments
Your time horizon on when you plan to use the funds, and your comfort with risk are the big determining factors when choosing the right mix of investments, no matter what type of account your money is in. You’ll earn more with aggressive investments, such as stock funds, if you are going to be investing for the long term. And that’s what a 401(k) is meant for, long term investment. The younger investor with many years to retirement is generally better off investing fairly aggressively within their 401(k).
As you get closer to retirement, within about ten years, you’ll want to be sure that your 401(k) earnings remain predictable. You won’t want to risk the fortune you’ve amassed, due to an unforeseen crisis that causes the stock market
to tumble. Investing more conservatively will help to preserve capital, to reduce the risk of losing money in a declining market. A gradual shift to less volatile bond funds will provide you with more safety, but at a slower growth rate.
As you get very near retirement, and closer to the day you begin taking distributions, it’s safest to become even more conservative with your investments. Begin to shift some of your 401(k) account funds into very stable investments to ensure your money is there when you need it. A money market fund has very little market risk, and though loss of principal in a money market fund is possible, it’s very rare. Money market funds strive to maintain its net asset value (NAV) of one dollar per share, even though the return on principal may fluctuate.
These are common guidelines on long-term investment planning, but your strategy may stray from those guidelines, depending on your unique situation. You may plan to take out a loan on your 401(k). If so, it would be a good idea
to put enough into a money market fund to cover the amount of your loan. That way, you won’t be forced to sell investments at a loss when you need the money.
Or, even as you near retirement, you may wish to keep a good portion of 401(k) funds invested fairly aggressively if you have more conservative investments in other retirement accounts, like an IRA. Many people will spendtwenty to thirty years in retirement, and you won’t want all your money stuck in conservative, low-paying investments for that long. Most likely, you won’t need to take all your 401(k) money at once in retirement, but rather as regular payments spread out over the rest of your life. Aim to have money needed for the short term in safer, more stable investments, while money needed in the long-term is still invested fairly aggressively.
Diversification is key
Now, you won’t want to risk all your money in one investment, even if you have a long time-frame to retirement. Proper asset allocation will help balance out the highs and lows of the market, and you’ll have more stable growth. Think about
those who made a short-term fortune in tech stocks a few years back. They were overjoyed at their impressive returns for quite some time; many of them believed the good times would never end. Then the tech bubble busted, and many saw their fortunes lose almost half their value. I have a friend who experienced just that; she had all her eggs in one basket, most of them got broken, and she had to return to work long after she believed she was retired.
Asset allocation means spreading out your investments so that you’ll still earn a good over-all return, even if one or a few investments don’t do so well. It means betting on a few horses, so you have a better chance at picking a
winner, rather than plunking all your cash on one horse and hoping for the best. Stock mutual funds are less risky than individual stocks, but they still come with risk. A nation’s economy may suffer, and so funds that invest in companies
in that country may do poorly. Or, an entire industry may take a hit, and so funds that are heavy in that sector may not perform well.
Since we can’t predict future market conditions, our best strategy is to diversify our investments. Aggressive investors aim for a portfolio heavy on stock funds, with a small portion in bond funds and cash. More conservative investors typically strive for a more balanced mix of stock funds and bond funds, with some in cash. Extremely conservative investors will invest mostly in bonds, with little in stock funds, and some in cash. Now, we’re talking about investments within your 401(k), and the mixes mentioned are for your over-all portfolio, including your bank account and other investments. So you don’t need to keep cash investments in your 401(k) until closer to retirement, as long as
you have enough cash saved elsewhere to get you by for short-term needs or emergencies.
Remember, whether you’re a conservative or aggressive investor has more to do with your time-span than your personality. Young investors should naturally be more aggressive in their retirement investments, but they’ll become more conservative as they get closer to the day they’ll need the money. Once you have decided the right percentage of stocks, bonds, and cash for your time horizon, a smart investor should further diversify by choosing different investments within those classes.
This is a short list of basic investments; the investments your company chooses to offer may be different.
- Large-cap stock funds – generally less volatile than other stock funds, but returns may also be lower
- Small-cap stock funds – can be very volatile, but long-term gains are often better
- Mid-cap stock funds – less volatile than small-caps, and more so than large-caps. The returns are in step with level of risk.
- Sector funds – invests heavily in one industry or related industries, can be very risky
- Domestic stock funds – may suffer if the U.S. economy suffers
- Foreign stock funds – may be affected by changes in foreign policies, currency fluctuations, wars, natural disasters, etc.
- Domestic bond funds – may choose from investment grade to junk grade, varying levels of risk associated with each
- Foreign bond funds – invests in debts originating in other countries, carry various levels of risk
Asset allocation made easyIt can be confusing for new investors to know which investments, and at what percentage, to put 401(k) contributions into. Then, they’ll need to check up on their investments and periodically re-balance their portfolio. But many 401(k)
participants fail to do that; they just let their contributions stay in the same investments they originally signed up for, even if it’s not the right investment mix for their current situation. This means keeping track of how investments are
doing, and being aware of the prevailing market conditions. It’s risky to ignore your portfolio, whether it’s by lack of knowledge, or just plain laziness.
Yes, there is an easy answer to it all! Enter, the target-date retirement fund. These mutual funds allow perfect portfolio balance, according to when you plan to retire. The target-date fund typically invests in many other mutual funds,
and the fund manager does the re-balancing for you as creep closer to retirement. Investing in just the one fund will give you exposure to a variety of investments, while limiting your market risk. Employers are beginning to offer the target-date retirement fund as a 401(k) investment choice. Some of them may not offer them yet, that is, until their employees begin to request them. These funds are an easy way to invest for your future, without all the time and work needed to manage such a diversified portfolio.
Fees eat away your gains
Always be aware of any fees that will reduce your over-all returns. 12b-1 fees and loads, or sales commissions are a common mutual fund charges that can dramatically lower your 401(k) balance. Pick no-load funds if you have a
choice, and ask your employer to switch if they only offer loaded funds. Also, plan administration fees or account maintenance fees can chip away at your nest egg, make sure you know of those fees. Individual service fees may apply if you take a loan on your 401(k) or make changes to your 401(k) plan.
Investing in company stock
One final note, let’s look at investing in your company’s stock. I’ve admitted to doing it myself when I was young, but that was before I knew better. Some employees may blindly invest in company stock out of loyalty. Or those with no
other investments may assume that any stock is better than no stock. This is a dangerous move, and can become a costly mistake. What if the company you work for comes crashing down? Then you could lose not only your job, but a good portion – or even all – of your retirement savings.
Don’t invest in your employer’s company stock for your 401(k) if you wouldn’t buy that stock with after-tax money out of your pocket. Research the company, see if the stock is performing well, and use your insider’s knowledge to
determine if the stock is likely to continue to do well. Then make your decision. If you work for a solid company, then company stock may have a place in your balanced 401(k) portfolio, especially if they give you a reduced price on it. But don’t risk your secure future on that company’s stock if you even suspect that the company you work for isn’t a winner.
Sources:
wikihow.com
pathtoinvesting.org
fidelity.com
