How Should I Invest My 401(k) Account?
In my previous blog titled, Surprise Yourself by Increasing Your Contributions, I discussed some of the things you can control when it comes to your company’s retirement plan. Many people are able to contribute to some type of employer sponsored retirement plan, but struggle to know how to allocate their accounts. In today’s blog, I am going to discuss 4 key points to consider when deciding how to invest in your 401(k) plan:
Let’s begin with the length of time that you are working with through your retirement. There seems to be a misconception that you should aim for your estimated retirement date. In reality, your investment money should last you through retirement. So, you should really look at the amount of time you would like your assets to last. For example, someone who has a long time horizon would benefit from being invested more heavily in an equity-weighted portfolio. This potentially provides greater return, but also higher volatility. In contrast, someone who is older and has only a few years before retirement would benefit from having a greater bond exposure in their portfolio. This potentially provides lower returns, but also lowers the volatility in the account.
With a longer time horizon, one can more comfortably handle an aggressively invested account. As the number of years to retirement reduces, it is important to be mindful and make adjustments as necessary. A retirement time horizon is strictly based on your goals and targets rather than a set time limit.
On a scale from 1 to 10 with 10 being very risky and 1 being ultra-conservative, where do you feel comfortable on the risk tolerance scale? Are you able to handle a large shift in the markets? Would a high risk positioned portfolio cause you to sell a fund at the wrong time?
Think about and figure out your personal risk tolerance number. This number will probably adjust over time and should be correlated with your time horizon. Since a younger person has a larger frame of time to work with, he has the time to be able to recoup unrealized losses and bounce back as the overall trend in the market increases over time.
Many plan providers offer enrollment booklets that offer a gauge or a note concerning the level of risk associated with each fund in the plan. Morningstar.com is also a good resource for this information and much more.
Diversification is the management of risk by combining multiple securities in the same asset class with several different asset classes. Fixed Income, Domestic Equity, International Equity, Emerging Markets, Real Estate are good examples of asset classes.
As of December 31st, 2014, the U.S. made up 52% of the world’s $47 trillion total equity market. The US bond market made up 29% of the world’s $37 trillion total bond market. Even though these figures are impressive for the United States, if you were only to invest in the U.S. economy, whether in the form of stocks or bonds, you are potentially limiting investment opportunities.
Investing internationally is one piece of a diversified portfolio. Opportunities such as real estate can also be a good option for another smaller portion of your portfolio.
Your account should be structured in a way in which you are invested in multiple funds, although age-based or target date funds (the funds with the future years in their name) have become a popular hands-off approach. Each target date fund automatically adjusts its asset mix over time to reduce the risk tolerance as you approach your retirement date. Different investment companies have varying philosophies on when age-based funds should automatically adjust themselves. Before selecting this type of fund, research the underlying methodology. You do not want to get too conservative too early, as you will need this money to last for many years after your retirement date. This is one of the reasons the Department of Labor has recently published literature on these types of funds for consumers. Also, the returns with most target date funds have historically not been outstanding, so make sure you look at the fund’s long term historic performance as well.
It is important to be disciplined when it comes to investing. Keep it simple. I often hear participants say something along the lines of, “Sally told me she is making a lot of money in that fund. I want in on that!” or "Dave says there is going to be a large drop in the market in a few weeks.” Yes, markets fluctuate, and we see growth and decline as we have in the past. If you let your emotions get involved with you and your investments, this can impact you adversely. Concentrate on your contributions and stay focused on your long-term retirement goal.
When you combine your specific time horizon and risk tolerance, people take an individualized approach to handling their investments. Don’t compete with other employees – focus on your own future.
Call your retirement plan’s advisor and ask to discuss your account. Review how it is invested and make adjustments if necessary. If your plan’s advisor does not proactively check in with you in the future, make a note in your calendar to try to touch base with your advisor on a regular basis. The feeling you will get from a periodic phone call can be uplifting and relieving. The feeling of retiring comfortably will be even better.