401(k) Investment Options – How To Choose
Now that we have a core understanding of 401(k) plan basics, we need to discuss how to go about making investment choices within the plan.
Because the 401(k) is the primary retirement savings vehicle for most American’s, how you choose to allocate, or fail to allocate, your 401(k) can mean the difference between a “happily-ever-after” retirement, and a “oh shit what do we do now” retirement.
I have met with hundreds of individual’s and families to review their 401(k) allocation, and have encountered some absolutely terrifying things.
As such, this post is lengthy, and spares no detail. However, once you are done, you will be well equipped to make intelligent, and appropriate decisions about how to best allocate your 401(k).
401(k) asset allocation is unique in that you, as the investor, do not have an unlimited range of options to choose from (as you would in an IRA, for example).
This decreases the importance of investment selection, and increases the importance of asset allocation.
Investment Selection Versus Asset Allocation
Investment management and selection is the process of choosing one specific investment over another, both of which are intended to serve the same purpose.
So for example, if you want to invest in a technology company, you may have to choose between investing in Apple and investing in Google.
Asset allocation, on the other hand, involves picking and choosing which asset classes to invest in, which is typically a precursor to investment selection.
In the above example involving Apple and Google, before you decided to invest in one of those two companies, you had to decide that you wanted to invest in technology companies.
While that is a very specific definition of asset allocation, within your 401(k), you will typically not be given such specific asset class to invest in. You will be choosing between stocks and bonds, or large-cap versus small-cap.
Whatever the case may be, because of your limited investment options, you don’t need to worry as much about the actual investment choices as you do about your overall allocation.
How Do I Determine My Optimal Asset Allocation?
The answer to this question is going to be different for everyone.
The first criteria to explore are your timeline and your risk tolerance.
As a 401(k) is intended to be a retirement account, most of the time your timeline will be, well, the time between now and when you plan to (or are thinking about) retiring.
However, there are certain circumstances that may warrant taking a loan out of your 401(k), or making a hardship withdrawal.
If this is the case, your timeline has changed, as you may need the money prior to retirement.
You first have determine what your timeline is, and go from there.
As a general rule of thumb, the longer the time between now and when you will need the assets, the more risk you are able to assume.
This is because what happens next month, next year, or even five years from now is really irrelevant.
If the S&P 500 loses half of its value next year, but you don’t need to take money out of your 401(k) for 40 years, does that really matter?
To the extent that it creates an emotional headache, it matters.
However, from a financial planning perspective, it doesn’t.
Unless you expect the world will be invaded by aliens and human monetary tools to become extinct, chances are that markets will bounce back.
40 years from now, are you really going to care what happened that long ago?
While timeline is important and lays the ground rules, it is by no means the end game. Just because you are 30 or 40 years from retirement does not mean that you have to assume more risk.
Some people are just not comfortable subjecting their assets to the whims of the market for extended periods of time, and that’s okay.
However, by limiting your risk, you are also limiting your potential for return.
While this is not inherently wrong, you will need to ensure that when you are creating your financial plan, that you project returns that may be lower than the average returns for more aggressive stock market investors.
On average, if you wish to achieve the same retirement lifestyle as a co-worker would, while also investing in less risky investments, you will have to either contribute more money to your accounts, or work for a longer period of time to make up for the lower returns.
Once you have determined what your risk tolerance and timeline is, you are ready to choose which investments are most appropriate for your 401(k).
Because everyone has different investment options, I can only speak in general terms. However, this should be enough information to allow you to make informed decisions.
Basically, this means don’t put all your eggs in one basket.
If the world suddenly changes from using primarily oil fuels to using primarily renewable energy fuels, and you own 100% oil stocks, guess what?
However, if only 10% of your portfolio was in oil stocks, you are in a much more manageable position.
While the maximum allocation to any one asset class varies, I generally suggest no more than 20% to any one asset class (asset classes are discussed in more detail below).
Two exceptions to this rule apply:
- 1. Company Stock
Many companies provide the option to purchase company stock in their 401(k). Other companies match your contributions with their own stock.
Whatever the case may be, I normally do not suggest holding more than 5% – 10% of your company’s stock in your 401(k).
This does not mean that your company is not great, that you and your colleagues are not awesome, or that your company will not perform extremely well in the future.
However, in sticking with our diversification theme, over-concentrated stock positions significantly increase your risks.
2. Target Date Funds
A target date fund is a fund that automatically changes its allocation as you get closer to the “target date,” which is presumed to be your retirement date.
So, if you invest in a target date fund with a target year of 2040, that fund will automatically adjust its allocation to go from risky to conservative as you get closer to your target date.
These funds are good for those who do not want to manually update their 401(k) allocation on a consistent basis (recommended at least annually).
However, the downside is that these funds typically do not take into account current economic trends.
So when 2008 came along, these funds did not account for the fact that we were in a major recession. They continued to keep the allocation as it was, which was arguably not the right course of action.
However, for those who wish to go this route, it is not inherently wrong to put 100% of your balance into these funds, because they are diversified, rebalanced, and updated for you on a regular basis.
Here is a great article discussing the pros and cons of target date mutual funds.
Asset Class Selection
As I said earlier, your specific investments, and asset class selection, will be unique.
Optimally, you would work with an advisor to assist you in making these decisions.
However, if you choose you do this on your own, I have listed below the most common asset classes available in 401(k) plans, in order from least risky to most risky:
- Cash & Money Market Fund
- U.S. Bond Fund
- International/Emerging Market Bond Fund
- U.S. Large-Cap Equity
- U.S. Mid-Cap Equity
- U.S. Small-Cap Equity
- International Equity
- Emerging Market Equity
For a more risk-tolerant investor, with a longer timeline, investments in equities, particularly emerging markets equities, may be most appropriate.
On the opposite end of the spectrum, as you approach retirement, or if you are more risk-averse, a heavy dose of cash, bonds, and occasionally large-cap U.S. equities would be most appropriate.
Putting it all together
You first need to understand yourself. Know your risk tolerance, your timeline, and what you want to achieve by investing in your 401(k).
Once you know this, you can choose which asset classes and investments are most appropriate.
Be careful not to allocate too much to company stock and other funds, unless you choose to invest in a target-date-fund.
And be mindful of the risk-spectrum of the asset classes available to you and how they impact your investment performance and ultimately your goals.
Have a question on a topic not covered, or an asset class not discussed? Feel free to let me know in the comments below and I’ll get back to you as soon as I can.
Remember, if you have a question, chances are there are others like you who have the same concerns!