Sizzling summer weather is just around the corner, so let's talk about a hot 401(k) topic: out of all those funds your plan offers, how can you know which ones to choose in order to get the best return on your 401(k) investment?
Well, if you are clairvoyant, the answer is simple. All you have to do is put all your money in the fund that you know is going to soar in value.
However, if you are like the rest of us, you have no idea which fund is going to rise more than the others. In this case, the best strategy is to use a carefully calculated combination of funds.
What is asset allocation, anyway?
The method used to calculate such a combination is called asset allocation. A good asset allocation is the Holy Grail of investing, but according to one recent survey most 401(k) participants don't even have an asset allocation strategy.
Asset allocation means dividing up (allocating) your investments (assets) in such a way that they work together to give you the smoothest ride toward your investment goal. The idea is to choose funds that are expected to do well in the long run, but that do not move up and down in synch with each other.
Imagine, for example, that you are driving up a mountain. One road leads you to your destination on a gradual slope. Another is a roller-coaster road that takes you up steep hills - some even higher than your destination - and down into deep valleys, eventually bringing you to your destination with one heck of a stomachache. Which one would you choose?
By spreading your 401(k) over several funds, you will not achieve the highest returns possible in your 401(k) each quarter. That would require putting your entire investment in the single fund that was going to do the best - and unless you are the clairvoyant that we were talking about earlier, you can't possibly know which fund that will be.
Asset allocation strategies
Asset allocation is based on modern portfolio theory, which says that the critical first step to developing a suitable investment account is deciding which types of assets you want to buy, not which individual stocks and bonds you like. Investing in many different asset classes makes more sense than worrying about whether a particular security is "safe enough" to put your money in.
Here's some help with developing the best asset allocation strategy for you. Of course, these are general guidelines that don't take into account the details of your particular situation, and they should be viewed as such. They are educated guesses that are based on historical data. When it comes to trying to predict the future, economists agree with the immortal patriot Patrick Henry, who said:
"I know of no way of judging of the future but by the past."
Below are pie charts that illustrate suggested asset allocations for different age groups based on the historical returns of and correlation between asset classes. (Correlation means how similarly the classes behave - for a more detailed explanation please see Wall Street 101.)
All allocations assume a retirement age of 65:
In your 60s?
In your 50s?
In your 40s?
Classify the funds in your plan
At this point you're probably thinking, "that's great, but I still don't know which funds in my plan to invest in." Hang on to your portfolios, investors, because that's what we're going to look at now.
You need to classify each of the funds in your 401(k) as large-company, small-company, international, bond, or money market fund. This is not as easy as it might seem, because in many cases you will find that a single mutual fund contains several asset classes.
How can you know what the funds in your plan contain? If you happen to have access to a list of all the securities held by the fund, you can figure it out that way, but most of us are not so privileged. If you enjoy crunching numbers, you can regress the mutual fund's returns against asset class proxies (indexes). If reading the previous sentence left you asking, "huh?" try making an educated guess through research on the Internet and by reviewing the fund's prospectus.
Once you have sorted your funds by asset class, you need to look at the pie chart that fits your situation and figure out how to divide up your investment so that it matches the specified percentages.
For the sake of illustration, say you have two funds in your plan. One is invested 70% in large companies, 20% in small companies, and 10% in international companies. The second is 80% in small companies and 20% in international companies. If you split your investment equally between the two funds your overall allocation would be 35% in large companies, 50% in small companies and 15% in international. (Add up the percentages and divide by the number of funds.)
You have now taken the most critical steps toward a 401(k) investment that is balanced in the way a professional financial planner would suggest.
You're not finished yet, though. What happens if your 401(k) plan has more than one fund option in any of the asset classes? You will have to make some choices.
There is no "correct" management style, but there are dramatically different styles, and you should pick funds that are managed the way YOU think is best. In deciding, you should consider the choice between index funds and actively managed funds, and between "value" and "growth."
Index funds track a predetermined, specific group of stocks. Also known as passively managed funds, they tend to have very low fees. Actively managed funds have higher fees, which are used (in part) to pay a portfolio manager who selects and trades stocks based on his or her opinion and outlook on specific stocks, industries, countries, etc. Historically, index fund returns have been hard to beat, but many people feel more comfortable knowing their money is being managed by a person.
In general, "value" funds focus on stocks with relatively low prices in relation to the company's current profits, cash flow and assets. "Growth" funds focus less on current profits and more on stocks with momentum and the potential for high future profits.
If your 401(k) plan has more than one fund option in any asset class, you face some tough choices on management style and other issues. To name a few, you should compare the funds' past performance, fees, assets, management tenure, and beta (price volatility relative to volatility of the market as a whole). Because each of these factors is important in "fine tuning" your 401(k), they will be addressed in upcoming articles.
Your specific situation
We recognize that every investor's objectives, risk tolerance, and time horizon is different, and we do not claim to be able to advise you on your specific situation without knowing details about your current situation and future plans.
If you like the idea of getting specific fund advice on your 401(k) plan, you might want to consider telling your manager or human resources department about 401k Forum. Our goal is to help individuals make the most of their 401(k) plans.