Over the course of an investor’s working life, only four factors have a real impact on the amount of money available for retirement. 1) The age the person begins saving; 2) The amount invested; 3) The allocation; and 4) The fees.
In a previous post, I covered the importance of starting young and most people recognize that saving more is a good way to have more available for retirement. Rather than recapping those concepts, here I’ll cover the last two: The Allocation & Fees.
An 85% Allocation to Stocks, Plus or Minus 15%
It isn’t uncommon for young investors to fear the stock market. They saw what happened after the tech bubble burst in 2000 and lived through the financial devastation of the Great Recession. Despite the passing of time, the memories are fresh and every hint of market volatility feels like the start of the next big collapse.
These fears tend to keep young investors allocated too heavily to safe investments like cash or bonds and underweighted to risk assets classes such as US and International stocks. Over the long term, this approach can have costly consequences. For example, $100,000 invested in a risky portfolio that averaged 8% returns would be worth $1,006,265 after 30 years whereas a low risk portfolio that averaged 4% returns over the same period would only be worth $324,339. A difference of $681,000.
As a young professional, it is important to own stocks. Yes, they can go down and sometimes they will go down a lot. This is the nature of the beast. But as a person under 40, time is on your side. Over a long investment horizon, stocks have historically outperformed bonds and starting in a low interest rate environment like the one we have today, this trend seems likely to persist into the future.
As a rule of thumb, advisors often use one hundred minus the investor’s age to quickly determine the appropriate percentage of stock ownership. A 30-year old, for example, would have 70% of the 401k in stocks and an 80-year old would have 20% in stocks. For a young person, however, this rule of thumb tends to overstate the appropriate fixed income allocation.
It is more accurate to simply say that the average person under 40 years old should have an allocation of 70 – 100% in stocks depending on his or her risk tolerance.
Knowing Your Risk Tolerance & Avoiding Mistakes
Part of managing a portfolio is knowing how to manage your emotions. Step one in this process is asking yourself what you would do if a stock market crash were to wipe out 40% of your portfolio’s value. Would you?
- Sell your stocks as fast as you could
- Do nothing
- Buy more stocks at a discount.
If you know you would want to sell as fast as you could to stop the pain, tone back the risk of the portfolio in advance. Instead of 85% in stocks, shift it down to 70% in stocks with larger allocations to bonds and cash. This way, if the stock market drops, your portfolio will experience less volatility and you will be less inclined to sell at the least opportune time.
If you answered B, the base case allocation will likely be good for you. Maintaining a portfolio of 80% – 90% stocks, diversified across the US and international markets is probably correct.
If you answered C, you may want a more aggressive approach and hold 90 – 100% stocks with almost no exposure to cash or bonds.
Picking Between Funds
One of the unique things about a 401k is that investors are typically forced to pick from a menu of options preselected by the employer. The process can seem daunting and sometimes it feels like throwing darts. But it doesn’t have to be that way.
First, if your firm offers target date or retirement dated funds, you can allocate 100% of your money to the fund that most closely matches your assumed year of retirement. For a young professional, this fund will automatically start with an aggressive allocation to stocks (US, international, large, mid, and small size companies) and slowly increasing the allocation to bonds and cash as the investor ages.
If a target date fund is unavailable or you prefer customizing a portfolio to your risk tolerance, start by picking the fund with the lowest expense ratio from each the following categories:
- Large Capitalization US Stock
- International Stock
- Fixed Income
Split your desired equity allocation to the US and international funds, and the rest to the fixed income fund. More aggressive investors will have higher allocations to international markets and little to no fixed income exposure. More conservative investors will have less international exposure and more fixed income.
While there is no way to know exactly how each fund will perform in the future, numerous studies have shown that the expense ratio is one of the strongest predictors of future success. Funds with lower fees tend to perform better than funds with higher fees. When given a limited menu of investment options, sorting by fees is a good starting point.
Of course, these are all generalities. Picking the right allocation is a very important, personal decision so consult an advisor about your investment options, goals and risk tolerance.
Here are a few more tips for selecting investments in your 401k:
- Picking multiple funds from the same asset class category does not add to your diversification. It would be like trying to diversify your diet by drinking several brands of whole milk.
- If your employer is a publicly traded company that allows you to buy its shares in your 401(k), don’t do it. Diversification is an important part of managing risk and investing for the long term. Owning shares of a single company, especially one that pays your salary, exposes your financial life to excess risk. Just ask Enron employees.
- Unless you are 100% invested in a Target Date Fund, it is important to rebalance the portfolio at least annually. This means selling some of the positions that have gone up in value, buying investments that have gone down in value and bringing the allocations back to their desired levels.