Are You Choosing the Right Investments in Your 401(k) Plan?
June 30, 2014It can be hard to figure out if the investment selections within your retirement plan investments are a good fit for your personal goals. The concept of diversification is usually represented by the phrase “don’t put all your eggs in one basket.” It makes perfect sense but how do you know which baskets are the best fit and how much do you put in each basket?
In the financial world, we often hear phrases such as “last year’s winners could be next year’s losers” and vice versa since the best performing asset classes usually change from year to year. If you are a visual person, take a look at the Callan Periodic Investment Table for an illustration of how different asset classes have performed over the past 20 years and how hard it is to predict. That why it’s usually a best practice to avoid trying to pick winners and losers and simply focus on following an asset allocation strategy that spreads risk and the opportunity for growth across different asset classes.
Asset allocation is the process of choosing investments across different asset classes such as stocks, bonds, real estate, and commodities. The main objective of asset allocation is to lower overall investment risk by reducing overall portfolio volatility. How you go about choosing your personal asset allocation depends on factors such as how long you have to reach your goal (a.k.a. “time horizon”) and your comfort level with the ups and downs of investment markets. This is usually referred to as risk tolerance. There are many risk tolerance questionnaires out there so it’s best to take at least 2-3 different ones to assess your comfort level for risk (see this investor quiz, Vanguard’s, or Financial Finesse’s for examples).
Once you have taken time to gauge your risk tolerance, you are in a better position to start creating and reviewing your investment portfolio. But don’t feel like you have to do this by yourself. Help exists if you are still not sure how to turn that seemingly simple concept of diversification into a real investment plan.
It is often easiest for novice investors who prefer taking a hands-off approach to build a properly diversified investment portfolio with “one stop shop” asset allocation funds like target date funds. But if you aren’t using an asset allocation fund and building your own portfolio, always keep in mind that it is essential to pay attention to sub-classes. Stocks come in different sizes based on the size of the company (small, mid and large cap). They also vary based on geographical location and that is why it’s generally recommended to look beyond the United States with part of your investments.
It’s often helpful to see the historic range of returns for different asset allocation models. Vanguard’s portfolio allocation page shows examples of different income-oriented, balanced, and growth-oriented approaches to investing. You can see how the average annual returns vary along with best years, worst years, and the number of years with negative returns. Schwab’s mutual fund portfolio-builder provides a similar illustration but also has a specific breakdown of large vs. small companies and international stocks.
In the past few years, many portfolio allocation tools and online account aggregation sites have popped up to provide you with a breakdown of your current asset mix. In many cases, you can get asset allocation guidance and suggestions for free. Check to see if your 401(k) provider offers asset allocation funds or portfolio guidance. Next week, we will also examine some popular account aggregation sites such as FutureAdvisor, Personal Capital and other so-called “robo-advisers” to help you monitor your investments. The main thing to remember is that asset allocation doesn’t have to be an overwhelming task and that you have options to help you create a diversified portfolio.