Smart 401(k) Investing—Investing in Your 401(k)
You can mitigate risk in your portfolio by distributing your investments among the three major asset classes: equity, fixed income and cash or cash equivalents. Investing in all three will help to protect you against major losses, since historically, stock, bonds, and cash investments not only produce returns in different ways, but tend to provide their strongest returns at different times. In most cases, if one asset class is performing poorly, the other two are doing better.
Asset allocation means assigning a percentage of your entire portfolio to each asset class. For example, if you were investing $10,000 and you allocated 30 percent to fixed income, you’d buy $3,000 worth of bonds.
Your investing style will determine what percentage of your portfolio you assign to each asset class. Depending upon a number of factors, including your age, risk tolerance and other retirement assets, your style might be described as aggressive, moderate or conservative. Aggressive investors’ portfolios target growth by investing heavily in stock and stock mutual funds, despite the risk of short-term losses that they carry. Moderate investors might invest 40 percent to 60 percent of their portfolios in stock or stock funds and the balance in bonds, bond funds or other fixed income investments. Conservative investors target capital preservation and weight their portfolios more heavily with cash investments.
Once you’ve determined the percentage you’re allocating to an asset class, you must decide how to invest the money that percentage represents.
For example, if you’re assigning 60 percent of your contribution to equities, and your 401(k) offers eight equity funds, you must decide which funds to use and whether to emphasize one rather than another or put money equally into each of your choices. There are no fixed rules for what’s best.
The key is to identify funds that invest in different segments of the equity market: large companies, small companies, companies that seem poised for growth and those that are ready to make a comeback. You might also consider an index fund, a balanced fund or a fund that invests internationally. That way, you’re in a better position to benefit from whichever of those segments of the market is performing best. Then follow the same approach for choosing bond funds, though you are likely to discover there are fewer of them in your plan.
You won’t necessarily want to use all the funds your plan offers. There’s little benefit to owning two funds that invest similarly, as two large-cap growth funds might, since owning the two provides no additional diversification.
What’s in a Name?
While a fund’s name is often a useful clue to its investment style, don’t take it at face value. Look at the fund’s prospectus using the EDGAR database on the SEC website, and check to see how the fund is classified by research companies. If a fund with "Small company" in its name has substantial investments in medium- and large-sized companies, it may not have all the diversification you’re seeking when you buy it.
Ideally, your investing style will provide the growth you need at a level of risk with which you’re comfortable. But keep in mind that both your needs and risk tolerance may change as you come closer to reaching any of your financial goals.
Unfortunately, no single allocation model provides strong results in all economic climates, and certain circumstances might suggest that you should deviate from more common allocation models. For example, if an employer’s pension promises regular income in retirement, you may be comfortable investing your 401(k) more aggressively than experts might recommend for your age.