When retirement is decades away, it's easy to get in the habit of ignoring your 401(k). After all, you're making your contributions according to your retirement plan, so why not just let the money sit there and do its thing? However, there's one annual task you can complete in just a few minutes that will boost your 401(k) returns remarkably: rebalancing your investments.
What is rebalancing?
Rebalancing your investments means restoring them to the correct asset allocation balance -- i.e., how you split your money between different types of investments. Having the correct asset allocation is critical for any portfolio, but it's especially important for retirement savings accounts.
When you drew up a retirement savings plan and figured out how much you needed to contribute, those figures assumed a certain average annual return on your investments. Even if your retirement planning consists of "this website says to contribute 15% of my salary, so that's what I'll do," that 15% number recommended to you is based on the ability to earn a decent return. And if you don't get the expected returns, you may end up with a shortage of savings no matter how diligently you contributed to your 401(k). Rebalancing is the key to keeping your average returns high.
Why asset allocation matters
Your needs for how your 401(k) account investments perform will change over time. Early in your career, when retirement is still far away, high returns are the most important factor. If that means putting your money in investments with high volatility, that's not a problem; should your investments tank they'll still have time to recover.
However, the closer you get to retirement (and the time when you'll start living on your 401(k) money), the less volatility you'll be able to tolerate. A market crash that's no big deal while you're in your 30s would be devastating in your 60s. It's still important to squeeze good returns out of your investments, but not at the cost of carrying a high level of risk.
That's where asset allocation can do its thing. Most savers keep their 401(k) money invested in stocks and bonds. Stocks have higher average annual returns than bonds do, but stocks are also more volatile than bonds. So early on in your career, most if not all of your 401(k) should be invested in stocks. Then, as you approach retirement, you should allocate a growing share of your savings into bonds.
Calculating asset allocation
In order to rebalance your investments, you need to know how your assets should be allocated. One rule of thumb is to subtract your age from 110 and keep that percentage of your 401(k) in stocks, with the remainder in bonds. Thus, a 30-year-old would have 80% of his 401(k) funds invested in stocks with the remaining 20% in bonds. A 50-year-old would have 60% in stocks and 40% in bonds. And so on.
It accordingly stands to reason that as time goes by, the original allocation in your 401(k) account will diverge from your updated asset allocation for two reasons. First, as you get older, your asset allocation needs will change over time according to the above formula. And second, because your stocks and bonds will be generating returns at different rates, the percentages will shift on their own.
For example, let's say you're 50 years old and have allocated your assets between 60% stocks and 40% bonds. A year goes by and the stock market is soaring, while bonds aren't doing so well. Because your stock investments are growing in value but your bonds aren't, by the end of the year your asset allocation may have drifted to 65% stocks/35% bonds. Now you're overexposed in stocks and if the market takes a sharp turn downward.
How to rebalance your 401(k)
Once a year, take the time to pull up your 401(k) balance and see how your money is allocated between stocks and bonds. Use the asset allocation formula to find out how much you should have in stocks versus bonds at this point, then compare that number to the actual percentages. If you have too much in stocks, sell some stocks and use the money to buy more bonds until the percentages are correct. If you have too much in bonds, do the opposite. Maxing out your 401(k) returns can be as simple as that.
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