How to Invest Your 401(k) Dollars
There is no such thing as a perfect portfolio
Despite the claims made by financial advisors and planners, in reality there is no real possibility of having the perfect portfolio that performs to your expectations. Most portfolio planning today uses some variation of the mean-variance optimization process invented by Harry Markowitz, and though this system does make sense, in reality it leaves a lot to be desired. This is because mean-variance based systems are based on one very specific circumstance that is based on the exact volatility, correlation, and returns you stipulate when setting up the calculation.
Since no one can effectively guess at future volatility and performance, these calculations are invariably wrong. The subsequent performance can be well below expectations, or even worse than just taking random guesses at the proper asset allocation.
Stocks versus bonds
Historically speaking, stocks always out perform bonds over a long period of time, but stocks are also more volatile, meaning that there is a greater risk involved. Young investors, people with more fifteen years to go before they intend to retire, need active capital growth in their 401(k) plans and also have enough time that they have the time to recoup any losses from dramatic downturns or crashes.
Although it looked very bad at the time, the stock market crash of September 2008 did not amount to a permanent blow to most young investors because they still have a long time to go before they access their 401(k) funds and much of the value lost has already been regained as of November 2009. Older investors who are planning on retiring within the next fifteen years have much less time to compensate for major losses, so they should probably invest more in bonds than stocks.
What stocks should you invest in?
There are many different types of stocks to choose from, though many 401(k) plans limit their participants to investing in mutual funds holding a basket of stocks. More often than not, these mutual funds are a better idea for people lacking an intimate knowledge of the market because they are managed and operated by professionals who have an intimate understanding of the markets.
Not only do most 401(k) plans limit your stock options to mutual funds, they also tend to limit the number of mutual funds available as well. Assuming this is the case, the best idea is to research those funds that are available and trace their performance over set period of time. Do not just look at individual performance, but look at compared performance. If two or more funds tend to balance each other out – one going up when the other goes down – consider invested in both in equal amounts. Examine your options closely and look for slow, even growth as opposed to the returns made by individual funds by themselves.
What bonds should you purchase?
As is the case with stocks, most 401(k) plans also limit bond holding to funds as opposed to separate issues. Further, many 401(k) plans are tilted in favor of stocks and provide fewer bond options to choose from. By its very nature, the bond market is trickier for non-professionals to understand, so going through a bond fund is probably a better option for most 401(k) holders anyway. That being said, the core of your bond holdings should probably be a total bond market index fund as opposed to many of the more specific bond funds that might be available. One thing that should be taken into consideration in the current climate is the continuing decline of the dollar, which will likely result in increased inflation. Using a mix of foreign and high-yield bonds as well as Treasury Inflation Protected Securities (TIPS), can offset inflation related losses, but should only account for ten to twenty percent of your bond allocation.
How many funds should you hold?
Many people, especially those with a lot of funds to choose from in their 401(k) plans tend to equate holding more funds with better diversification. However, this is not really the case at all; the issue is not how many funds you hold but what those funds invest in and whether or not your funds balance each other. As a general rule of thumb it is better for most people to hold as few funds as possible because the more you hold the more complicated your planning and tracking becomes. While savvy investors with a good understanding of the markets may make more money by using many different funds, for most people using their 401(k) to save for their retirement, holding more funds just complicates the process.