Regular contributions to your 401(k) for the long haul will build wealth for your retirement. But it's not enough to put the money in the account -- you also have to invest it wisely.
There are many 401(k) investing best practices, but the big ones are keeping your holdings diversified and investing in accordance with your risk tolerance. These are important because they protect you from unnecessary volatility, and also undue stress.
The good news is, even if you have only a handful of investment options in your 401(k), you can easily practice diversification and risk-aware investing. Here are three solid strategies to get you started.
1. Target-date funds
Target-date funds (TDF) are diversified funds that address the tendency of long-term savers to shift from investing for growth to investing for stability as the retirement date nears. TDFs do this by adjusting their asset mix to be gradually more conservative over time. The timeline of that adjustment is hinged on the date in the fund's name, which should align with your targeted retirement year.
Some TDFs reach their most conservative asset mix in the target year, while others do so a few years later. Therein lies one of the confusions of TDF investing. They're positioned as a one-stop shop for retirement investors. But picking a TDF that's designed for your projected retirement year doesn't guarantee the fund will match your risk tolerance.
There's an easy fix, however. First, decide on the approach you prefer. In the early years of retirement, are you willing to accept volatility for a shot at higher returns? Or, do you want stability once you retire, even it if means lower returns going forward? Then, review the glide paths of your fund options. The glide path defines how the fund's asset mix will change over time.
If the TDF available for your retirement year doesn't feel right, try a different year. A fund with an earlier year will be more conservative, and a fund with a later year will be more aggressive.
Once you pick a TDF, remember to check on its performance at least annually. If the fund doesn't perform, look at other options.
2. Target-risk funds
Target-risk funds invest in other funds in a mix that's tailored to a specific risk profile. The Vanguard family, for example, labels its target-risk funds as conservative, income, moderate growth, or growth. And Lincoln Financial has target-risk funds that are conservative, moderate, or aggressive/growth.
As with TDFs, you can narrow your choices by the fund's name, but you should also review the fund's strategy and asset mix before you buy. And then, be aware that target-risk funds do not adjust their asset mix over time. Make it a point to consider annually whether that fund still matches your risk profile and investing goal.
3. DIY diversification
If you prefer a hands-on approach, you can build your own target-risk portfolio. You'd do that by splitting your contributions across funds that pursue different investing strategies. Generally, you can assume the following about relative risk levels for common asset classes.
- Money market funds are more conservative than bond funds.
- Bonds are more conservative than stocks. And within the bond category, government bonds are the most conservative, followed by corporate bonds, and then international bonds.
- Large-cap stocks are less volatile than small- and medium-cap stocks. And domestic stocks are less volatile than international stocks.
An aggressive but risky portfolio would have a high percentage of stocks, say 70%. The remaining 30% would be invested in bonds and cash. A conservative portfolio would be heavily weighted in bonds instead.
If you diversify on your own, plan on resetting your targeted asset mix once annually. This practice is called rebalancing. Say you initially allocated 60% of your contributions to stock holdings. After a year, those stocks have grown in value -- and they now make up 65% of your portfolio. To get back to your targeted 60%, you'd sell off some of those stocks and use the proceeds to invest in other asset classes.
Diversify and honor your risk tolerance
If you want low-maintenance investing in your 401(k), a single TDF may be the only position you need for the long haul. Or you might prefer to invest according to your current risk appetite alone, without having to worry about the complexities of glide paths. You'd accomplish that goal with a target-risk fund. And if neither of those options feel right, you can build your own portfolio of mutual funds across asset classes.
All three approaches will land you a diversified portfolio. And if you do a little homework on your fund options, you can easily tailor your risk level, too.