Investing, Retirement

5 Easy Steps to Choose Investments for Your 401(k)

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One of the most important financial decisions you will make is how to invest the money you are putting in your 401(k).  Target date funds are the default option for most retirement plans, but in a prior post I showed that target date funds aren’t the best option for most people.  If target date funds aren’t the answer, what is?

Regular readers know that I advocate a widely diversified portfolio built on a foundation of low-cost index funds.  This simple strategy will give you the greatest chance of achieving superior results over time.  How can you implement such a plan? 

Develop a “Micawber Principle Portfolio” of Your Own

Follow these 5 easy steps to develop a “Micawber Principle Portfolio” of your own:

1.  Allocate Your Investment between Stocks and Bonds: The first step is to determine how much of your investment to put at risk in the stock market. This is different for everyone and will be based on your unique risk profile. For most people this will be between 25% and 90%. To determine how much risk you should take, start by reviewing the following posts:

2.  Narrow Your Choices: Narrow your investment choices down to a low cost index fund in each of the following categories:

  • A large company U.S. stock fund indexed to the S&P 500. Vanguard’s 500 Index Fund (VFINX) is an example that many plans offer.
  • A U.S. equity fund indexed to the Dow Jones U.S. Completion Total Stock Market Index. This will include stocks of small to medium sized U.S. companies not in the S&P 500. Vanguard’s Extended Market Index Fund (VEXMX) is an example that many plans offer.  
  • A developed market international stock fund indexed to the Morgan Stanley Capital International Europe, Australasia, Far East Index (MSCI EAFE). Vanguard’s Developed Markets Index Fund (VDVIX) is an example that many plans offer.
  • A short-term U.S. securities government bond fund. Vanguard’s Short-Term Federal Fund (VSGBX) is an example that many plans offer.
  • A broadly diversified U.S bond fund indexed to Barclay’s Capital Aggregate Bond Index. This will invest not only in government bonds but also corporate bonds. Vanguard’s Total Bond Market Index Fund (VBMFX) is an example offered by many plans.

3.  Allocate Your Money Between the Funds as Follows:

  • International Stocks: Adding international stocks to your portfolio can lower risk without lowering the expected return. Most experts recommend allocating between 20% and 40% of the stock portion of your investment to international stocks. Unless you have a reason to go lower or higher use 30% as the default.
  • Small Company U.S. Stocks: Over long periods of time small company stocks have a higher return than large company stocks, but they are much more volatile. Small company stocks can add extra return to your portfolio, but they add extra risk to do so. Allocate between 10% and 30% of the stock portion of your investment to small company stocks. Use 20% as the default and depart from this if you want to take more or less risk.
  • Large Company U.S. Stocks (S&P 500 Index): Allocate the remainder of the stock portion of your investment to the S&P 500 index fund. This will be anywhere from 30% to 70% of the stock portion of your investment depending on your allocations to international and small company stocks above.
  • Allocate the Bond Portion of Your Investment: Divide the bond portion of your investment between the two bond funds you chose. Use a 50/50 split as the default. A higher allocation to the government bond fund will lower your risk, while a higher allocation to the total bond fund will increase your risk.

4.  Rebalance: At least once a year rebalance your portfolio back to the allocations you chose in steps 1 through 3.  Over time your various investments will perform differently and the allocations you chose above will change. Rebalance back to your original allocations by selling assets that have performed well and buying assets that have performed poorly. Rebalancing can also be done by adjusting how much you purchase of each asset each pay period (this is my preferred rebalancing method).

5.  Stick to Your Plan: Don’t try to time the market. Don’t try to figure out whether small or large stocks, or U.S. or international stocks, will do better in the next year. Don’t panic if the market tanks. Only change your plan if your personal risk profile changes. Otherwise, simply stick to your plan.

Example

Here is an example of how this would work in practice.

  • After determining your risk profile you decide it would be appropriate to allocate 75% of your investment to stocks and 25% to bonds.
  • International Stocks: You determine to use the default above and allocate 30% of the stock portion of your investment to international stocks. This would be 22.5% of your total investment (75% x .30).
  • Small U.S. Stocks: You determine to use the default above and allocate 20% of the stock portion of your investment to small stocks. This would be 15% of your total investment (75% x .20).
  • Large U.S. Stocks: This leaves 50% of your stock allocation for large U.S. stocks, which is 37.5% of your total investment (75% x .50).
  • Bonds: You determine to use the default and split your bond allocation 50/50 between the two bond funds, which is 12.5% of your total investment to each bond fund (25% x .50).

Using these simple steps will allow you to quickly and easily develop a low-cost retirement portfolio customized to your unique risk profile, and with fees far less than you would pay for a target date fund.  This method will give you the best chance of achieving superior results over time, and you can do it with a minimum investment of time and effort.  Happy investing.

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