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Due to the bull
market of the past 10 years, many 401k 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 401k
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 401k. An
asset allocation strategy can be applied to investment inside and
outside of your 401k. This article deals strictly with asset
allocation within your 401k.
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
401k and 401k 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 401k 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 401k 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 401k 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.
Another very important thing to
research is fund purity. To read more about this, check out an
excerpt from our upcoming Wall Street 201 investing course.
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 401k 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 401k 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 401k 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 401k 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 401k 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) 401k, 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.
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