401(k) Step 2: Slicing Up the Pie
For anyone new to handling her own finances, the array of investment choices provided by a typical 401(k) plan can be dizzying. Unfamiliar names jump out from the "asset allocation" sign-up sheet -- sometimes there will be 20 or more choices offered, and usually employers offer little help in determining which allocation might be the right one for you.
The typical investment choices in a 401(k) plan are likely to be:
- Money market funds or stable value accounts
- Bond mutual funds
- Stock mutual funds
Kidding. Llamas are not offered as an investment vehicle under any 401(k) plans. If your 401(k) is for some reason offering llamas, consider instead working for a company that is not run by somebody who's insane. Choosing to invest in llamas cannot possibly help your retirement. Now, back to the boring stuff.
Money-market funds and stable value accounts: The types of accounts offer secure ways to make sure that your savings grow at a limited rate. You won't make much off any money put into these vehicles, but you don't stand much chance of losing any either, as they consist mainly of certificates of deposit or U.S. Treasury securities.
- Risk: Low
- Reward: Likewise low, around 2%-5% a year
Bond mutual funds: These are pooled amounts of money invested in bonds. Bonds are IOUs, or debt, issued by companies or by governments. A purchaser of a bond is lending money to the issuer, and will usually collect some regular interest payments until the money is returned. Usually, the amount of interest paid -- the coupon -- is fixed at a set percentage of the amount invested. Thus, bonds are called "fixed-income" investments.
- Risk: Ranges from very safe (U.S. Treasury securities) to somewhat risky (so-called "high-yield" or "junk" bonds)
- Return: From 4%-8% a year
Stock or equity mutual funds: Such funds are pooled amounts of money that are invested in stocks. Stocks represent part ownership, or equity, in corporations, and the goal of stock ownership is to see the value of the companies increase over time.
- Risk: Stocks can and do lose 10% to 30% of their value in a matter of days, and more than half their value over a year or two.
- Return: 10.4% average, with years from around -40% to +50%.
Those are the main categories, though not likely the only choices you'll find in your 401(k). Chances are, your options are broken up into even more categories, such as large stocks and small stocks; U.S. and international stocks; corporate and government bonds; and maybe even a real estate or commodities fund. Given all the possible ingredients, how do you decide on the right investment soup for you?
If you have a 401(k) plan administrator, she won't tell you how to invest your money. Generally, plan administrators won't expose themselves to any legal liability and won't offer specific investment advice -- markets, after all, don't end up behaving in predictable ways all the time. Or any of the time.
We can't offer specific investment advice to you either, because we don't know your specific situation. (Our Rule Your Retirement service, however, does provide asset allocation models, specific investment ideas, and a place for you to discuss your specific situation with a staff of knowledgeable folks.) But we can help you narrow your choices. Let's start by asking another question: Given that stocks have higher historical returns, why invest anywhere else?
Well, given that we've seen two brutal bear markets so far in the 2000s, we probably don't need to remind you that stocks don't always produce those historical double-digit returns. Plus, there's always the possibility that the future won't look like the past, even over the long term.
So, if you're less than a decade from retirement -- or you just can't stand to see your nest egg drop 50% in value -- then you should hold cash and bonds as well as stocks. If you're lucky, your 401(k) contains target retirement funds, which provide a reasonable asset allocation based on when you'll need the money. A while back Rule Your Retirement editor Robert Brokamp interviewed Newsweek columnist Jane Bryant Quinn, author of the excellent book Smart and Simple Financial Strategies for Busy People, and she provided an excellent argument for choosing target retirement funds:
The reason I like them is they are basically one-decision funds. If you go to professional advisors, what will they tell you? They will tell you to allocate your assets, and they are going to give you more stocks when you are younger. As you reach middle age, they are going to modify that a little, and when you retire, you will have a more moderate portfolio. And then when you are 80, it will be mostly an income fund. They [advisors] will charge a hefty fee to do this for you.
The target retirement fund does it for you automatically. It is a wonderful, professional product that gives you appropriate asset allocation for your age, and it rebalances, which folks never do with their own investments. Even if they understand it, they never do it because it is hard.
We second all those sentiments, and emphasize the "allocate your assets" and "rebalances" parts. Unless you're a master stock picker, you need a broadly diversified portfolio, and you need to rebalance regularly -- selling what has done well, buying what might be ready for its turn. Target retirement funds do it all for you. Nowadays, they're offered in many employer plans and by most of the low-cost mutual fund companies, including Vanguard and T. Rowe Price.
Those who are young and are putting money away for two decades or more, however, should consider an all-stock portfolio, with a healthy dose of small and international stocks. (Target retirement funds, while we like them, tend to be more conservative, holding cash, bonds, and a large helping of larger stocks, even for investors in their 20s.) But even choosing to invest 100% in stocks doesn't answer all your questions. After all, you now have to pick the right stock mutual fund. There's a good chance that your 401(k) has the right fund for you. Want to know what it is? Read on.