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Updated on Thursday, February 7, 2019
A 401(k) or other employer-sponsored account allows you to save money from your paycheck regularly, with the option to stash that money in a variety of investments. In most cases, your contributions are pre-tax, reducing your taxable income; you’ll pay taxes on the money — and any earnings — when you withdraw the money in retirement. If you have access to a Roth 401(k), your contributions are after-tax and all withdrawals in retirement are tax-free.
In either case, the 401(k) investment options available to you are ultimately up to your employer and the plan they’ve chosen. Allocating your money effectively among those investments is essential to your savings success.
401(k) asset allocation refers to the way you divide up your contributions among different investments. Diversification is important because if you put all your money into one asset class and it performs poorly, you stand to lose a lot.
“I’ve seen situations where people have put 100% of their money in the previous year’s best-performing asset class, just to see it become the worst performing asset class,” said Ted Toal, a financial planner in Annapolis, Maryland. “That’s why asset allocation is so important. You own a little bit of everything.”
Here’s how to optimize and maintain your 401(k) asset allocation.
How to diversify your investments
You know you should diversify and own a little bit of everything — but what does that mean? At the highest level, common advice is to diversify between stocks, which tend to be more aggressive, and bonds, which are more conservative. Some rules of thumb attach the suggested stock/bond percentage to your age, but it’s more about your risk tolerance. The more you have in stocks, the greater your risk — but the more you stand to potentially gain. An aggressive portfolio might have 80% to 90% of its assets in stocks.
“My advice is, always be a little more aggressive in a 401(k) than you would be if you had a lump sum to invest,” Toal said. “You have time, and down market volatility can work in your favor.”
In other words, because you’re putting money into the market at regular intervals throughout the year, a down market means your money goes further — and there’s presumably plenty of time for the market to rebound. So be as aggressive as you can stand, Toal suggested.
Further diversification involves the types of stocks and bonds you’re in. For stocks, consider categories such as:
- U.S. large-cap companies
- U.S. mid-cap companies
- U.S. small-cap companies
- International stocks
- Emerging market stocks
While the ultimate mix is up to you, small-cap, international and emerging market stocks tend to be riskier than other asset classes, so the average investor may put less money in those than in other categories.
You can put together a portfolio yourself, or you can also consider a ready-made portfolio choice such as a target-date fund. A target-date fund allows you to purchase a mutual fund based on your retirement year (2060, for instance) and the fund diversifies your money for you, automatically becoming more conservative as you near your retirement date.
Some 401(k)s also offer asset allocation funds, where you can choose a conservative, moderate, or moderate aggressive portfolio and your money will be invested accordingly. Some might offer a balanced fund, in which your money is distributed among stocks and bonds somewhat evenly (usually about 60/40).
“If people aren’t comfortable with the target-date fund, there’s nothing wrong with a balanced fund, or even a static asset allocation fund where you’re always moderate and it doesn’t shift,” said Marguerita Cheng, a financial planner in Gaithersburg, Maryland. “Any one of those three choices would be totally appropriate for a new 401(k) investor.”
How does risk tolerance affect things?
How you feel about risk is something to keep in mind as you’re designing your portfolio. Your risk tolerance is essentially how you feel about the idea of losing money. If your portfolio loses 20% in a market dip, are you going to pull your money out and put it elsewhere? What about 50%?
If thinking about a big dip in your investments makes you queasy, you may be better off in a portfolio with less risk exposure. Generally, that means investing in more bonds and fewer stocks, or prioritizing stocks in less risky categories, such as large-cap U.S. stocks. If you’re investing for the long term and a market fall doesn’t bother you (perhaps because you realize that you’re now buying investments at a discount), you may choose a more aggressive stance.
Toal, however, nods to risk tolerance but suggests that it’s not as important as some experts make it seem. “Risk tolerance will shift,” Toal said. “Coming out of last year, people will answer a risk tolerance questionnaire differently than they would have two years ago. It’s simply understanding markets and that markets will go down and that’s simply part of investing.”
How much does past performance matter?
In general, past performance is not an indicator of what an investment will do in the future, so it shouldn’t be your sole reason for investing in something.
“New clients will come in and when I see their allocation, I’ll ask them how they determined where their money is and why they’re putting it there,” Toal said “And they’ll tell me they pulled out the returns from the previous year and picked one or two funds that had high returns. That’s a terrible way to allocate your 401(k).”
While past performance isn’t a big metric you should consider, that doesn’t mean it’s meaningless. “It’s important to see how a particular investment performed relative to its asset class,” Cheng said. In other words, if a fund had a bad year, but not as bad a year as other funds in its asset class, that suggests that it might be a better pick than another comparable fund.
How often should you rebalance?
Rebalancing your 401(k) is the act of returning your portfolio’s allocations to the percentages you chose when you initially invested. For instance, if you decided to invest in 85% stocks and 15% bonds a year ago, market movement and investment performance may have resulted in a portfolio that is now 92% stocks and 8% bonds. To rebalance, you would sell some stocks and buy some bonds to return your mix to its original balance.
“Emotionally, sometimes it doesn’t feel right, because you are selling something that’s doing well and buying something else that’s doing poorly,” Toal said. “But that’s exactly what you want to do — sell high and buy low. That’s how you make money in the market in the long term.”
Consider rebalancing about once a year — or every six months at the most. Some 401(k) plans offer the option of automatic rebalancing on this kind of schedule. You likely won’t need to do it more often anyway.
“When you’re making ongoing contributions, you’ll find that your account tends to stay in balance a little better because, naturally, the money will go to where it needs to be,” Toal said.
What you should know about fees
To a certain extent, 401(k) fees are out of your control. Your employer chooses the 401(k) plan that’s available to you, and most fees aren’t optional.
That said, there are some things to be aware of. Among your investments, you should be paying attention to the expense ratio, which is the cost to run the fund each year. If you’re choosing between two funds that are similar in other ways, choosing the one with the lower expense ratio will net you more money at the end of the year, because you’ll pay less in fees.
Some plans also charge a fee for enrolling in automatic rebalancing. Check with your plan administrator to find out what optional service fees you may be facing.
In the end, asset allocation is a crucial part of your 401(k) contributions. Distributing your money among the right balance of investments can ensure that you’re balanced when the market is volatile and that you’re in the right position for earnings success. If you’re unsure of how to allocate your funds, a financial advisor can offer guidance.