Congratulations! Now that you've opened a 401(k) account with your employer and started your contributions, you've taken an important step in retirement planning. Now how can you ensure that you'll get the most out of it?
1. Make a diversified investment plan
Lack of diversification is a major cause of poor investment performance. Whether your portfolio is concentrated in company stock or in your favorite index, you'll be better off in the long run if you diversify.
To start, decide on your stocks versus bonds allocation and build from there. The key consideration here is what level of risk you can handle. If you're relatively young, consider tilting your portfolio mostly toward equities, which have higher long-run returns. However, if allocating 80% of your portfolio to stocks will keep you up at night, it may be worth saving yourself the anxiety to invest more conservatively.
Once you pick a big-picture allocation, it's time to diversify. The key is to get exposure to several different asset classes as cheaply as possible. This can take the form of a mix of index funds covering large and small domestic stocks, corporate bonds of varying risks, and international stocks. You could also consider a target-date fund, which allocates funds based on the year you plan to retire, adjusting its positions and lowering its risk profile as you near retirement. Similarly, lifestyle funds invest your money in a blend of assets according to your risk tolerance and your investing time horizon.
Pick the strategy that you're most likely to stick with. If you want a "set it and forget it"style, you may be better off with the packaged fund. Just remember to do your homework by checking out the actual allocation percentages and the fees.
2. Consider low-cost index funds
High fees can cause serious damage to your returns over time, so you'll want to be extremely fee-conscious. If you want to assemble a portfolio of mutual funds, consider investing in low-cost index funds instead (in the case of target-date or lifestyle funds, search for options that are built from index funds instead of actively managed ones).
Active managers might boast better performance at times, but that outperformance is both costly and difficult to predict. With index funds, on the other hand, you more fully enjoy the benefit of their performance because you're not surrendering a large portion of your returns to pay the managers.
One analysis found that the Vanguard Total Stock Market index fund outperformed its actively managed competitors about 77% of the time. Based on the expected performance of all actively managed funds, the author concluded that a "winner" would need to outperform the Vanguard fund by 5.4% to make up for the poor-performance risk that comes with active management. Currently, the median winner only outperforms the Vanguard fund by about 1%.
Again, the root of the problem is high fees -- and the fact that it's difficult to consistently beat the market, even if you're a professional money manager. Put the two together, and you have a strong case for passive investment-management.
3. Stick with the plan
Finally, be disciplined and stick with your plan. That means avoiding the extra fees that come from trading in and out of different funds or buying and selling the hottest stock. While individual trades may not seem too costly on their own, they really add up over time and erode your returns.
If you have a well-diversified portfolio, all you need to do is rebalance every now and again. This will bring your asset allocations back into alignment as certain positions grow or shrink depending on their performance. Advice differs on how often you should rebalance, but remember to minimize costs. For example, you could check your portfolio once a year and rebalance only if your allocations are way out of whack -- say, by 5% or 10%. Pick a number depending on your risk tolerance: If you get worried when your portfolio has too much equity, your margin of error might be lower.
Investors using target-date or lifestyle funds don't need to worry about rebalancing at all, as fund managers do it for them.
Practicing this kind of discipline can be challenging, and it's admittedly a rather boring approach to investing. But it works because it minimizes costs and helps you maintain a long-term perspective. So let the market do what it does and take advantage of that extra time to think about other things -- like remembering to raise your deferral rate when you get your next raise!
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