The one decision that primarily determines what the return on your 401(k) plan will be is the basic allocation between equity (stocks) and fixed income investments (bonds). This decision is driven by your tolerance for risk. The individual investor should view risk in terms of the ability to tolerate losses, either temporary or permanent. Studies show that 90% of the return in investment portfolios is determined by the asset allocation as opposed to the selection of securities, market timing and other factors.
The pertinent facts are these:
Stocks historically have returned, on average, around 10% but in any given year that return could have been as much as 50% higher or lower.
Fixed income investments have returned, on average, 4% but in any given year that return could have been plus or minus 5%.
The more stocks you have in a portfolio, the higher the return will be but the higher the probability that there will be periods of significant decline in the value of the portfolio. There may be circumstances where these losses are permanent.
Even with the volatility, stocks are the only asset class that has historically offered investors sufficient returns to outpace the retirement killing combination of taxes and inflation. So they must be present in a portfolio if you are to have any chance of successfully saving for retirement.
Given the above, it is vital that you honestly and thoroughly determine how much risk you are willing to tolerate and choose a basic (stock/bond) asset allocation that is going to produce results that you are comfortable with and that will give sufficient returns that allow you to meet your retirement goals. The goal of this exercise is simple - to choose an asset allocation that will give you adequate return to meet your retirement investing goals but also returns that will never cause you to have to consider selling into market downturns, particularly severe downturns. Greedily rushing to buy into strong markets and panic selling into market routs are the prime reasons that individual investors consistently show performance that is dismally less that market index returns. Choosing a basic asset allocation that you are comfortable with and sticking with it will avoid this behavior.
This is the one area of 401(k) investing for which I strongly recommend that you consult with a qualified investment professional. I recommend this because it is not only the most important part of the investment decision making process, but it is also the decision that investors most often get wrong. Seek out an independent, fee-only investment advisor (one that accepts no commissions and sells no financial products) and ask them to assist you in allocating your 401(k). They will help you for an hourly fee (usually in the $100 to $200 per hour range) and the engagement should take no more than two to three hours. If you are lucky enough to have a plan advisor call and ask for an appointment. Some 401(k) plans have advisors that work for the plan or the plan vendor that can assist you. Find out though, how they are paid. Be wary if they are paid by selling investment products to your plan. This should be detailed on you plan’s fee disclosure that must be provided to you annually. The advisor should ask you a series of questions designed to determine how you would react if various events occurred in your portfolio. At a minimum the advisor should help you come up with an asset allocation that determines what percentage of your retirement savings should be invested in the following asset classes:
Domestic Stock Funds
Money Market or Stable Value Funds
The recommendations may be more detailed depending on the complexity of your plan and how much of the advisor’s time you are willing to pay for.
Warning: If you use an online asset allocation program or if you specifically asked an advisor to help you only with your 401(k) allocation and If you are asked questions about assets other than what is in your 401(k) plan or asked to provide details about your financial situation either by an advisor or online - go elsewhere. This often becomes a “fishing expedition” to attempt to sell you financial products. Our experience is that this is a particular problem with commissioned brokers and the websites of mutual fund and insurance companies.
The Rule of Thumb
Many investment professionals counsel individual investors to use this simple formula to make the basic allocation for their 401(k):
100 - Age = % Invested In Stocks
During a person’s working life that would give the following allocations:
20 80% 20% -38%
30 70% 30% -34%
40 60% 40% -30%
50 50% 50% -25%
60 40% 60% -20%
70 30% 70% -15%
In general we find that this short cut works for 70 to 75% of our clients. There are individuals whose risk tolerance cannot be related to age. It is important to remember that our tolerance for risk is unique to each of us and is “hard wired” into our brains. It is very dangerous for investors to use portfolios that may give results that are outside their comfort level because sooner or later, they will, and the investors will be tempted to not stay the course and cause themselves considerable damage. For this reason we have included the losses that would have been incurred by these portfolios during the “great recession” in 2008-2009. It is important before you use this shortcut that you be honest with yourself and ask yourself if you could have tolerated losses of that magnitude.