Question: I have a 401(k) plan where I work. In the plan, there are about 20 investment choices. I would like to participate in the plan and contribute as much as I can afford, but I am completely baffled by the choices I have to make. Can you give me some advice on how to invest in my plan?
Answer: A small percentage of employees eligible for a 401(k) plan will actually participate, make the maximum contributions, and earn market rates of return on their investments. Some don’t participate at all, make only token contributions, or make poor investment decisions that result in low rates of return. Your desire to participate in your plan and to make wise investment choices is admirable and means that you understand the importance of using a tax-deferred plan to save for retirement.
I will divide my advice to you into two parts: (1) asset allocation, and (2) investment choices. This week I will cover asset allocation.
Asset allocation refers to the way you diversify to reduce risk by spreading your investments around in your account. There are three major classifications of asset classes available inside a 401(k) account: Cash Equivalents, Bonds, and Equities. Within each classification, you will find one or more subordinate asset classes available to you. These include:
Money market funds
Short-term Government Bonds
Intermediate-term Government Bonds
Long-term Government Bonds
International or Global Bonds
Large, Midsize, and Small Value Stocks, which are characterized by low price-earnings ratios, low price-to-book ratios, and high dividend yields.
Large, Midsize, and Small Growth Stocks, which are characterized by high sales growth, high return on equity, and low dividends.
International Stocks, which are sometimes further broken down into large, midsize, small, value, and growth.
Emerging Markets Stocks, which represent securities in companies inside developing countries around the world.
Real Estate Stocks, which are publicly traded real estate investment trusts.
Sector Specific Stocks like energy, healthcare, and financial.
Your first step to design a prudent asset allocation in your 401(k) is to determine which of the above asset classes are represented by the mutual funds available in your plan. Some of the better 401(k) plans will have them all. Your plan sponsor can provide you with this information.
The next step is to use the available asset classes to determine an allocation. You design the allocation to meet your goals, and this is where it gets tricky. You will want to optimize your expected rate of return to match an expected risk level that allows you to remain comfortable during volatile and down markets. Your plan sponsor may not help you with this, so you’ll probably have to do some research either on the Internet or at the library. Or, if you have a financial advisor, ask him or her for help.
The third step is to fill the asset classes you have chosen for your plan with the best choices of mutual funds provided by your plan. Next week, I’ll tell you how to do this.
Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment advisor and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning. Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA93940 or email them to firstname.lastname@example.org.