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Due to the bull market of the past 10 years, many
401(k) participants have been fortunate enough to experience unprecedented investment
returns.
This has led some plan participants to
abandon a risk-reducing asset allocation strategy and follow the market. However, this
exposes them to potentially debilitating losses.
If you are contributing to a 401(k) plan, you are no doubt
aware of the capitalist credo, "it takes money to make money." Yet, in a market
that can rise just as soon as fall; a market subject to emotions and global shifts, that
same credo might be better written, "it takes wisely invested money to make
money."
Divvying up your investments among different asset classes
is called asset allocation.
The best way to think about it: "Asset allocation is
really a risk reduction strategy," said Michael Horwitz, a certified financial
planner with Austin Asset Management.
It is one of the most important, and often least planned
out, aspects of saving in a 401(k). An asset allocation strategy can be applied to
investment inside and outside of your 401(k). This article deals strictly with asset
allocation within your 401(k).
By allocating your assets according to your risk tolerance,
years to retirement and the financial needs you foresee yourself having in retirement, you
can reduce the risk of not achieving the retirement lifestyle you've imagined for
yourself.
In this, the first of our exclusive three-part series on
asset allocation, we will cover the basics of allocation. Subsequent articles will deal
with rebalancing your 401(k) and 401(k) day traders.
Wake Up and Start Dreaming
An indispensable step in proper asset allocation is simply
deciding what you want your retirement to be like, and what expenses that will entail. You
probably have a dream that puts a smile on your face — whether it be sailing around
the world or building furniture. But, don't forget day-to-day expenses, or unforeseen
costs like health care.
Indeed, savers who know how much they need for retirement
generally have five times more money in their 401(k) plans than people who don't know,
according to the Employee Benefit Research Institute (EBRI) 1999 Retirement Confidence
Survey.
Taking the time to think about living arrangements, monthly
bills, food, and entertainment expenditures can help you define what kind of financial
shape you need to be in when you reach retirement.
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| More Info |
| The percentage of American workers who have
tried to calculate how much money they will need to save for retirement has risen from 35
percent in 1993 to 53 percent in 2000, according to the Employee Benefit Research
Institute (EBRI) 2000 Retirement Confidence Survey. |
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Your Risk Threshold
After nailing down a realistic picture of your retirement,
you can decide the extent of the financial chances you are willing to take to fulfill
those dreams. This is called risk tolerance.
Assessing your tolerance for risk can be thought of as
figuring out how willing you are to accept drops in value in your 401(k) account. More
volatile investments, such as high-tech equities or high-yield ("junk") bonds,
carry with them not only a greater chance for gain but a greater chance for loss, than,
say, more stable investments like short-term bonds or blue-chip stocks.
Think about your current and past money habits, if you have
no investment history, to determine how you deal with risk. Do you accept loss well, or do
money issues make the veins in your forehead pop out? Are you willing to ride out the
storm of a down market?
From 1926 to 1999, the stock market, as measured by the Dow
Jones Industrial Average, recorded 23 down years. That's nearly one out of three years.
You need to determine if you can deal with those down years without selling your
investments at a loss.
In thinking about risk, "we are dealing with human
behavior," said Horwitz. "... if a client is going to overreact to a negative
return in their portfolio by switching from equities to cash, in a sense undoing their
plan, that has to be taken into account." Remember, you only lose money if you
actually sell the stocks when they're down, rather than holding on to them until they go
back up.
Risk can also come into play if you are not on track to
meet your retirement goals. If, for example, you have five years until retirement, and are
not financially prepared, you may have to take on more risk than you are comfortable with
to achieve your goals.
Below are three charts showing how you can change the level
of risk in your portfolio by adjusting your equity holdings (bonds generally being a less
risky investment).
Investment Choices
With a clear goal in mind and a feel for your level of
tolerable risk, it's time to acquaint yourself with your investment options. Don't shy
away from researching your fund choices; it will pay off in the end.
"There is no substitute for looking at readily
available reports (on your 401(k) investment choices)," said Horwitz.
Researching a fund, depending upon how in depth you want to
go, can be a multi-layered and time-consuming process. In general, financial planners
suggest that you review investment policy, managerial style, and historical performance,
at the very least.
You can learn a lot about a mutual fund from the
prospectus. There are other sources available as well, both online and in print.
The investment options most commonly found in 401(k) plans
are stocks, bonds and cash (money market funds). A further delineation can be made between
large-capitalization (large-cap) stocks, middle capitalization (mid-cap), small
capitalization (small-cap) stocks and international stocks. These may be divided into
"value" stock funds and "growth" stock funds.
Here is a quick look at the most common 401(k) investment
options.
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| Stock Market Capitalization |
| Capitalization or "cap" is
calculated by multiplying the number of outstanding shares by the current market price of
a share. |
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Large-cap Stock Funds: Large-cap stock funds
generally have a median market capitalization of more than $5 billion to $10 billion.
These stock funds are made up of large companies, like GE.
Mid-cap Stock Funds: Mid-cap stock funds normally
have a median market capitalization of between $2 billion and $10 billion.
Small-cap Stock Funds: Small-cap stock funds
typically have a median market capitalization of less than $2 billion.
International Stock Funds: International stock funds
invest in equity securities of issuers located outside of the United States.
Global Stock Funds: This type of mutual fund
generally includes at least 25 percent foreign securities in its portfolio.
Bond Funds: Bonds are usually divided between longer
maturity and shorter maturity. Short-term bonds are generally considered to be less risky
than long-term bonds. A bond fund is always replacing bonds in its portfolio to maintain
its average maturity objective. You may also have a foreign bond option.
Stable Value Funds: These funds can provide an
attractive alternative to bond funds or money market funds in a 401(k) plan. These funds
invest in stable value contracts with insurance companies or banks, and their market risk
is generally less than that of a stock or bond fund.
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"When you do asset allocation,
you are taking the crystal ball and throwing it in the closet."
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| — Scott Leonard,
CFP and owner of Leonard Capital Management. |
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Money Market Funds: Sometimes referred to as
"cash," money market funds are like bank savings accounts in that the value of
your original investment does not fluctuate. However, they are not guaranteed like a bank
savings account would be, and the interest rate is generally lower than for stock and bond
funds.
Index Funds: These funds are invested to replicate
an existing market index such as the S&P 500, which is an index of 500 large U.S.
company stocks.
Company Stock Funds: These funds allow you to invest
in the company you work for. Company stock funds are not diversified investments, which
makes them theoretically more volatile than a mutual fund.
Emerging Market Funds: These funds are made up of
stock of companies located in developing nations.
Life Cycle Funds: A life cycle fund is a mutual fund
geared toward investors in a certain age group or with a specific time horizon for
investing.
Different Strategies
So, now we come to the rub. Asset allocation comes down to
combining the different asset classes in a way that reduces your overall investment risk,
and therefore the risk of not achieving your goal.
"The question of how much to allocate to each column
has been debated for years and there is no simple answer," said Nikki Ross, certified
financial planner and author of Lessons from the Legends of Wall Street: How Warren
Buffet, Benjamin Graham, Phil Fisher, T. Rowe Price and John Templeton Can Help You Grow
Rich.
Some financial planners recommend that their clients invest
70 percent of assets in stocks and 30 percent in bonds. Some suggest an 80-20 split. Some
want their clients to invest 100 percent in equities. Every situation is different and
demands a unique, investor-specific strategy.
"You don't have to be in every asset class (your
401(k) plan offers). For example, if are offered five different classes, you don't have to
be in cash or money markets, but you should be in all three equity classes (large-cap,
small-cap and international)," said Scott Lummer, chief investment officer at mPower.
When deciding on how to divide up your 401(k) investment,
you have to ask yourself some questions: How long do you have until retirement? What rate
of return will allow you to achieve your retirement goals? What level of risk are you
comfortable with? And, how much can you invest annually?
Generally, the longer you have to retirement, the longer
you have to weather market downturns and the more aggressive you can be. As you move
toward retirement, many financial planners suggest that you move at least some of your
money into more conservative investments.
However, if you are planning to be retired for a number of
years, you will need to keep some of your portfolio in aggressive investments, to outpace
inflation.
It's a long-term strategy. "If you have a high savings
rate and can save 15 percent of salary through (a) 401(k), and diversify, there's no
question you will attain a high level of wealth over a 20-year period," said Horwitz.
So, asset allocation allows for a trade-off of substantial
risk for a better probability of achieving your financial goals. Asset allocation may not
produce the best return-on-investment you can achieve, but that's not the goal. The goal,
through diversifying, is to minimizing your risk and keep you from having to guess about
what will be hot and what won't in the market.
"When you do asset allocation, you are taking the
crystal ball and throwing it in the closet," said Scott Leonard, CFP and owner of
Leonard Capital Management.
mPower Senior Writer Clifton Linton contributed to this
article. |