How to choose your 401(k) investments

Most people spend more time planning where they are taking the family on a summer vacation rather than on how they will invest their 401(k).  And it’s hard to blame them. Staring at a list of 30 + mutual funds they have never heard of, grouped in unknown categories like Aggressive, Real Return, or Mid Cap Growth is much more frightening than Googling “where to go on vacation”.  I would recommend that the best place to start is to consult your Financial Advisor.   However, if you don’t have that option here are some guidelines to tackle this important task.

For the business plans I am the Advisor to, I like it break it down into three broad decisions for or the plan participants; the one minute, the 10 minute, or The Infinite.

The One Minute Decision

Target Date Funds. You have probably seen these in your plan and they are designed to be simple and straightforward.    They usually shows up as an option that has a fund company’s name on it followed by “Target 2025” or some other date with a similar one with a date every 5 or 10 years.  The decision on which to choose is just simple math.  Determine when you want to retire and pick the Target Date closest to that year.  So someone who is 50 years old today who wants to retire when he is 65 does the math and adds 15 years to 2013 and comes up with a retirement year of 2028.  Looking at his options he could go with a 2025 or 2030 fund.  It supposed to be that straightforward.

However, it’s important to understand what you are getting and what you are giving up when you choose this option.  What Target Date Funds do at a basic level is have an asset allocation that will change as it approaches that target date.  This is known as its glide path.  When a particular target date fund is 40 years away it may have a very large concentration in more risky assets such Equities and REITs, International Equities and very little in Bonds.  As it gets closer to the target date that position will eventually flip.  There is no set allocation from one fund family to the next; each has its own philosophy on what the asset allocation should be.  In addition some of the glide path asset allocations will stop at the target date while others will continue on their glide path past that date.  Along with being adjusted as time goes by, the funds will be rebalanced regularly back towards their targeted asset allocation for that year.

One of the major downsides to this approach is that because there is only one fund for each retirement date, the funds are not customized to an individual investors needs.  They are generally “middle of the road” investments which may or may not match your investment risk tolerance.  You may be able to take on more risk and theoretically gain more return or, on the other hand, not like the volatility and want something more stable.

The 10 Minute Decision

The next level of sophistication is an asset allocation model.   Usually this is shown as a series of pie charts or in a matrix format.  What these models offer that the Target Date options don’t is risk tolerance; they will add options that will fall under groupings such as conservative, moderate, aggressive as well as options in between.  So now instead of just picking a fund closest to your target date, you are also selecting one within your risk tolerance.   Why I call this the 10 minute option is the added time to determine your risk tolerance.  Usually an online questionnaire is answered and it analyzes your risk tolerance.  You take that result and find the portfolio that invests in your level of risk tolerance.  Often they will also have options at each level of risk that adds the time dimension to it as well.  In that case you then find the one that is closest to your retirement date.

Just like the Target Date funds the asset allocation models have professional management determining what funds are in the models and how the models are allocated.  In addition they will automatically rebalance and adjust as you get closer to your retirement date.

The Infinite Decision

Finally the last, most time consuming and most flexible way to invest is to pick your own funds from your plan’s lineup based upon your own requirements.  You can spend as much time as you want doing this and you have full reign to determine your own asset allocation, make adjustments, and rebalance.  Often there will be online tools with your plan to help you determine a risk tolerance and suitable mix, but selecting the individual funds will be entirely yours.  This can allow you to get creative and really target your investments to your needs.  However if you don’t have the knowledge to do this correctly the results can be disastrous.  Remember, there were a lot of people who thought they were sufficiently diversified in 2000 and 2008.

Other Considerations

Fees

It’s important to understand the fees charged for each fund.  While the overall fees charged by the plan provider will be uniform no matter what you choose to do, the fees for the individual mutual funds will vary.  Obviously this is a much bigger deal for the Infinite Decision of choosing your own options, as the other two will have set lineups that are what they are.   You may want to look at using low cost index funds in place of actively managed funds in areas that tend to be efficient like Large Cap U.S. Companies.  Actively managed mutual funds have had a hard time adding value that outweighs their extra cost in these areas consistently.

Track Record

If you are choosing to use an actively managed mutual fund you will want to understand how it has performed in the past, you need to do your due diligence. Just because one fund outperformed another in the small cap space doesn’t necessarily mean it’s a better choice.  Styles go in and out of favor; growth oriented funds perform better for a year or two then value oriented funds do better.  Even within the growth and value camps there are subsets, and all have their day in the sun.  If you find one you like make sure you understand the management of the fund, if it had performed great for a few years under one management team and now there is a different manager, it could be a whole new ballgame.  There are a lot of criteria that should go into how you select an investment that is much deeper in scope than this article can cover.   You can consult a number of sources online to help determine what your due diligence process should be.

Consider Other Assets

Do you have other assets that are designated for retirement?  This could include old 401(k)s from previous employers, IRAs, brokerage accounts, annuities, and even your spouse’s 401(K)?  While it may be difficult for an individual investor to do you can work with your Financial Advisor to look at your investments holistically and look to maximize efficiency.   Putting investments in the proper accounts can provide tax efficiency as well as cost efficiency keeping more of your money in your pocket.  The idea is to manage your accounts and the investment options within to utilize each ones strengths and to be as efficient as possible.

Consulting a Financial Advisor

If all of this still sounds worse than the 2 hour wait at Disney for “It’s a Small World” , or if you would just like the opinion of a Financial Advisor, we are happy to help.

Past performance is no guarantee of future performance.  This article and the materials contained herein do not constitute the solicitation to obtain clients or provide personalized investment advice for compensation, in your state over the Internet, but is limited to the dissemination of general information on products and services that the Advisor can provide.  Information in this article must not be relied upon in connection with any investment decision.  Consult with your financial advisor before making any investment decision.  The views expressed in the linked articles or those of individuals not part of Berls Asset Management are those of the authors themselves and not necessarily those of Berls Asset Management.  Copyright 2003 Berls Asset Management all rights reserved.