MEET AMERICA’S retirement savings vehicle: the 401(k) plan. Perhaps, instead, you know one of its close cousins: the 403(b), 457 or federal government’s Thrift Savings Plan. These are called defined contribution plans because employees must decide how much to contribute. On top of that, employees are responsible for choosing which investments to buy.
This is a daunting challenge—with high stakes. These decisions determine how much folks will have when they retire. How can you make the most of these plans? There’s plenty of good advice available on how to pick the right investments. But if I was going to strip it down to the essentials, I’d offer these six guiding principles:
1. Don’t chase performance. This is probably the most common mistake investors make. Too often, they choose funds based solely on past performance. Such rearview mirror investing often disappoints, as the best-performing funds in one period are rarely the best performing in the next. This behavior is especially dangerous during market bubbles, such as the technology stock bubble of the late 1990s, which burst in early 2000, hurting many investors.
2. Beware company stock. If your employer’s stock is one of the investment options, it should comprise no more than 10% of your total 401(k) allocation. This is because a single stock is far riskier than a diversified mutual fund. For employees, holding company stock is worth an average 42% less than its stated value, once you adjust for the much higher risk involved, according to estimates by economist Lisa Meulbroek.
By owning shares of the company where you work, both your livelihood and your retirement savings will be at risk should your company go bust. Never forget the lessons of Enron and Lehman Brothers.
3. Gravitate toward target-date funds. If your 401(k) offers target-date funds—also called lifecycle or age-based funds—they’re a great option. A target-date fund pools together multiple funds—including stock, bond and money market funds—in a risk-appropriate manner. Financial professionals determine the fund’s investment mix based on the retirement year that the fund is targeting.
There are many other attractive features of target-date funds. Asset allocation automatically adjusts as you age, becoming more conservative over time. The funds are also rebalanced automatically. Finally, this is a great way to simplify a portfolio. You can literally have your entire 401(k) invested in a single target-date fund and be well diversified. In short, target-date funds are the perfect choice for those who want to “set it and forget it.”
4. Beware naïve diversification. While it’s always prudent to diversify, don’t blindly buy equal amounts of every available fund in your 401(k). Such naïve diversification will often lead to unintended consequences.
For example, if your 401(k) has eight stock funds and two bond funds, buying equal amounts of each will lead to an allocation that’s 80% stocks and 20% bonds. This is a relatively aggressive asset allocation and may not be what you intended.
A single fund, such as a target-date fund, may be all you need. Alternatively, a two-fund portfolio—a global stock fund and a total bond-market fund—may give you sufficient diversification. International funds invest solely outside the U.S., but global funds generally invest in both U.S. and international markets, so they give you worldwide stock exposure.
5. Lean toward low-cost, broadly diversified index funds. The majority of actively managed funds underperform index funds over the long haul. This is due to higher expenses and the behavioral traps that often trip up active managers.
By sticking with low-cost index funds, you’ll outperform 70% to 80% of mutual funds over the long run. But beware: Not every index fund is low cost. Be sure to look at a fund’s expense ratio before investing.
6. Avoid home-country bias. As U.S.-based investors, it’s tempting to stick to U.S. stock funds and shun international ones. This is a mistake on two counts. First, by diversifying globally, your portfolio will be less volatile because U.S. and international stocks are imperfectly correlated.
Second, U.S. and international stocks historically have taken turns when it comes to market leadership. Yes, U.S. stocks have greatly outperformed over the past decade. But if history is any guide, international stocks will lead the way over the decade ahead.
John Lim is a physician and author of “How to Raise Your Child’s Financial IQ,” which is available as both a free PDF and a Kindle edition. Follow John on Twitter @JohnTLim and check out his earlier articles.