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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.
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I am a financial advisor and many people come to me with a portfolio of target date funds (TDFs) and some recommendations in this article should be taken with a big dose of caution. I’ve seen portfolios with TDFs where the account holder has effectively “grown out of” being a TDF investor. When your portfolio reaches a certain size, it’s time to add certain asset classes which TDFs typically do not hold. This might include REITs, junk bonds, or narrow country based funds such as Japan-only funds or funds which have commodity exposure. Also, this advice of “set it and forget it” is bad advice. People should use tools available to analyze portfolio holdings to find if their holdings are staying true to their investment choices. TDFs really should be thought of as entry level products for many investors which, with time, they (hopefully) outgrow. Lastly, a TDF makes NO distinction between a 35 yr old single, non-parent who has a great tolerance for risk and a 35 yr old married parent of two who gets nervous every time the market dips. I have seen first hand really bad behavior where a 60 yr old single man “adjusts” his risk tolerance higher by holding a TDF which is meant for a person 30 yrs younger. This article mentions NONE of these caveats (and there are many more.)
Thank you, John. Combining your points 3, 4, 5, I would add that we might be better off mimicking a target date fund with the simplest low cost funds possible than paying the higher fees packed into target date funds. Combining points 5 and 6, I would wonder whether the largest US companies are as internationally diversified, without currency exchange risks, as a similar list of internationally based companies. After all, US company funds are often if not always the lowest cost funds, and for US-based investors that is our home country. This might be a reason, as well, for a bias toward larger US companies over smaller ones.
Dr. Lim makes some good points , But some confusing ones also. under #1 he says not to chose funds on past performance. But under #6, He’s basically telling us to look at past performance.
Perhaps confusing but it makes sense. Looking at actively managed fund with a track record of beating the market over 1, 3, 5 or even 10 years is one thing. But it is also very different than looking a broad history of markets and looking at history (often over 10, 20, 30+ yrs.)
If you have investments outside a 401k, consider your overall mix of equity/debt, US/international, etc. when reviewing the diversification of your holdings. If you are still contributing to a 401k plan, you are in a great position to dollar cost average towards your overall investment target or switch investments without tax consequences.
John – excellent post. I would welcome some discussion on the investment vehicles commonly offered inside of employer-sponsored retirement plans (indexed mutual funds versus variable annuities with investment sub-accounts). A discussion of the cost of both (the posted costs versus the “real cost” after sub-account advisor fees are deducted from a participants annual returns).
For many educators, a VA funded retirement plan may be their only 403(b) option while actively working. Yes, there is an insurance element to the VA option that can be valuable to the retiree or their heirs at some point, but this important piece gets ignored all too often. Some VAs inside employer-sponsored can potentially reduce the retirees realized net return by more than 1.50% (or more) annually due to sub account management fees.
For those not valuing the insurance benefit of a VA, a rollover to a traditional IRA funded with indexed mutual funds after retirement could be worth considering. But, there are other variables tied to this potential TQ investment vehicle change (post-retirement) that need to be weighed as well.
Good post!
Is a 401(k) a retirement plan or a pension plan? It makes a big difference when there is a pre-nuptial agreement involved. The ERISA law governs pension plans and a pre-nup governs retirement plans. A pre-nup can’t override ERISA law.
Perhaps even better advice: figure out how to stay happily married–it’s a great investment.
Both defined contribution and defined benefit employee-based retirement plans are covered by ERISA.
Thank you for that clarification.