The best 401(k) investment strategies involve a handful of tested principles that, when combined, will set any investor up for success in retirement. Debates will always rage about the best trading strategy or which stocks to hold at a given time. There may never be any consensus on those specifics, but adhering to a number of basic, guiding rules is a great way to get the most of any investment strategy.
Time horizon is hugely important
An investor's age is likely the most important determinant of their ideal 401(k) allocation. A pre-retiree who intends to start spending in five years has a completely different set of priorities from a 30-year-old who has several decades before they can make qualifying withdrawals without a penalty.
Over the long term, stock returns tend to reflect the financial performance of the underlying company. Similarly, long-term market performance should ultimately track the results of all publicly traded companies, which in turn are a decent (if imperfect) proxy for the overall economy. In modern economic history, global GDP has trended consistently upward, with only temporary interruptions for recessions and depressions. Stock indexes have followed suit. The S&P 500 has incurred numerous down years since 1950, but it was only negative over a five or 10-year span on very rare occasions, and has never averaged less than 6% annualized returns over any rolling 15-year window during the last 70 years. There are periodic downturns and interruptions to growth, but the stock market has always expanded over a sufficiently long time frame.
The key lesson from this data is that investors with short time horizons need to be wary of cyclical volatility. A downturn could wipe out savings that retirees may never be able to recover, so people approaching or in retirement should allocate a substantial portion of their 401(k) and IRA to bonds. Conversely, young people have nothing but time to ride out temporary losses and should be looking to take full advantage of long-term growth. They need to maximize equity exposure for anything above a 20-year time horizon.
Diversify your investments
Diversification is cliched and boring, but it is a nearly universal necessity in 401(k) and IRA allocations. Even top companies can fall from grace. Here's an example.
Blackberry (NYSE:BB) was once a leader in the smartphone market. As recently as 2010, the company held over 30% of U.S. operating system market share, and it sold more than 50 million devices in 2011. Blackberry bet that consumers would prefer a physical keyboard to touch screens, and it never actively encouraged third parties to develop a varied and dynamic user experience with applications. Today, Blackberry has essentially abandoned mobile devices to focus on security software for the Internet-of-Things.
Blackberry is a cautionary tale about over confidence in high-flying stocks, especially in the tech industry, where quick replacement cycles can rapidly alter popularity among fickle consumers. Retirement savers cannot bet their long-term holdings on the performance of a small handful of companies. Circumstances can change rapidly these days, both for individual companies and entire markets. Investors should make sure they aren't over-exposed to any single stock, industry, sector, geography, or company size. Portfolios should also be rebalanced periodically to ensure that recently appreciated categories are not disproportionately represented in the allocation. Diversification and balance ensure that unexpected events don't exert undue influence on your retirement account.
Various expenses can erode account values, but some are less obvious than others. Operating expenses in mutual funds and exchange-traded funds (ETFs) are obvious costs that are disclosed in a fund prospectus, represented by expense ratios. Investors should ensure that expense ratios are commensurate with the value created by fund management. For asset managers who add a lot of value above simple indexing, it's OK to pay for that service, but it's completely fair to be skeptical that this value can be delivered over the long term.
Trading costs are the most relevant hidden expenses in retirement accounts, and these include flat trading fees, commissions, bid-ask spreads, and embedded tax liabilities in high-turnover mutual funds. Savings can be realized by reducing trading volume in a retirement account to the minimum amount required to maintain target allocation.
Allocating for optimized volatility, achieving sufficient diversification, and minimizing expenses are important principles to follow, and they should all be applicable to any sound 401(k) and IRA investment strategy. These rules provide successful outcomes in retirement savings and growth. Once the investments are handled, retirees should research tax-efficient withdrawal strategies. Remember, 401(k) and IRA withdrawals are taxed as ordinary income, while other assets might be tax-free or subject to capital gains.