Last week I gave you the shocking news that there was free money to be had for many of you from your boss. Since I didn’t get many (or any) emails about it from stunned readers, I’m guessing all of you already knew this. But I never cease to be amazed by how many people leave this free money on the table by not participating in their company’s 401(k) plan.
In my last post, I recommended you contribute “as much as you can” without causing yourself any short-term financial difficulties. If even contributing 1% of your income will cause you to miss a rent payment or some other crucial expense, then you should put off participating. But, “I’m young and have lots of time so I’ll start contributing later” is a really bad reason to pass up the free money! Let the power of compounding work for you; start now if you can! Even if you only make a 1% contribution, it’s a great start!
But what if your employer doesn’t offer a matching contribution? Well, that means there’s no free money, but you still get the tax benefit of putting pre-tax funds into the plan, and having it grow tax-free (you pay tax when you take it out of your account).
Ok, enough about why you should participate, now back to what to do with your account. My last two posts have talked a lot of the core of your portfolio as well as index funds, so I will only say one more thing about the core before moving on to the satellites: in a 401(k), you have a limited number of funds from which to choose (also known as its “lineup”), which is not the case with other types of investment accounts. And for some very strange reason, sometimes the people who decide on which mutual funds to offer (for a small company it’s the owner; for a large company it’s usually outsourced to an investment firm) don’t want to offer many index funds.
If this is true of the plan you are in, do your best: opt for a very large US Stock fund (a Total Market fund is best), a broad-based bond fund (Total Bond Market fund if available), and an International fund that hopefully covers at least several countries or a region such as Europe.
So when your core is in place, it’s time to think about your satellite funds. A few things to keep in mind: while diversification is good, you certainly don’t need to (nor should you) put money into every fund the plan offers. Having a “portfolio” of 8-10 mutual funds in your 401(k) is plenty. One thing I always recommend against is having less than 5% of your plan in any one specific fund. An allocation of 2% or 3% really isn’t going to contribute much to your overall performance, and doesn’t do much for diversification either. It’s basically just noise – eliminate the noise!
As I said last week, when it comes to stocks, I like to use actively managed funds in the “value” and “growth” spaces. And you really only need 3 funds to build a good satellite portion of your portfolio in the stocks space: a large cap value fund, a large cap growth fund, and a small cap value fund. That’s it!
Why no small cap growth fund? Academic research has shown that over the long-term, small cap and value have outperformed other stock categories, so this is a good way to tilt your allocation to the value side of things.
I also don’t like mid cap funds. You can use them, there’s nothing bad or harmful about them, I just don’t think they add anything valuable to your portfolio. They mostly just add noise, and some funds that are classified as mid cap by Morningstar are not really mid cap funds at all (I explore this in a lot more detail in my second book due out in February). I think you can build a great portfolio without them.
On the bond side of things, your satellite only needs 2 funds: a Total Return fund and a High Yield fund. There are many good Total Return bond funds out there, and I can’t recall ever seeing a 401(k) lineup that didn’t include one. What is a “High Yield” bond fund? It’s one that buys bonds with high yields, or course!
Ok, what that means to you is that the bonds in the fund’s portfolio are largely or entirely “non-investment-grade”. These bonds carry above-average risk, so the “yields” they offer to investors are also above average. There are a lot of good managers who are very adept at managing this increased risk, and so I think a high yield fund is not a bad idea for your 401(k); but don’t put more than 10% of your money in it (5% is usually enough). I’m not a big fan of taking undue risks in a 401(k).
So that’s it: that’s the structure of what should be a successful, long-term 401(k) account. Now, within this structure, which particular funds do you choose? Often there is a choice between 2 or even 3 funds within several of the investment style categories. I will be giving you some professional fund analysis techniques in my next book, Building Lifetime Wealth. For now, I’ll say: don’t just pick the fund’s with the best historical performance and call it a day. A fund’s return, also known as reward, is only one half of the risk/reward equation. You also want to look at the risk level of the funds being offered in the lineup. I prefer using funds in 401(k) whose risk level is below average; more on that in the very near future.
I’ll wrap up this 3-post series on 401(k)s in a few days talking about other types of funds you might see in your 401(k) lineup.
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