Retirement plan decisions made easy
Drill Down: Asset Allocation: Bringing It All Together
It’s time to get away from theory and history to focus on your decision: how to allocate the assets in your 401k among your various investment options.
Here are the basic principles.
• If you have the option of investing in individual stocks, do NOT choose it.
Stick with mutual funds. You need to be diversified within each asset class, and all mutual funds are diversified within the limits of their investment strategy. (That means that if the mutual fund is investing in large American companies, it has a diversified group of such companies. However, it is not diversified into small company stocks, or foreign stocks.)
If you truly want to invest in individual stocks, here’s how to do it. Use mutual funds as your core holdings. Once it looks like you will meet your investment goals, use any excess money you have to play with individual stocks
• If you have the choice of investing in your company’s stock, do NOT do it.
Even if you think your company is great and its stock will go up, do NOT invest your 401k assets in the company stock. First, investing heavily in any one stock is risky. Second, this isn’t just any old company, it’s your paycheck. If the company falls on hard times, you may be out of a job at the same time that your 401k has lost a great deal of its value.
The Enron Story:
Enron began its life as a natural gas pipeline company, but became a large, highly regarded corporation trading energy in different forms. It was a stock market high-flyer, one of the most respected companies in America. Fortune Magazine named Enron “America’s Most Innovative Company” for six consecutive years. Unfortunately, it turned out that the company’s accounting was misleading, and Enron went bankrupt.
The company’s matching contribution in 401k accounts was Enron stock. Employees were limited in their ability to sell the Enron stock that they received as matching contributions. However, employees were free to choose from a wide selection of mutual funds in which to invest their own contributions. Instead of choosing from among these mutual funds, many employees chose to invest their contributions in Enron stock because it had been doing so well. Those employees ended up losing both their jobs and most of their 401k.
The employees who had diversified their 401k investments by putting all of their own contributions into stock and bond mutual funds ended up all right. The amount that the company matched became worthless, but at least these employees retained their own contributions with good returns.
• Include stock mutual funds in your asset allocation.
You can allocate all of your funds to stocks if you are young and willing to take on a good deal of risk. You can also be in entirely in stocks if you have more than enough money, so that even a stinking decade of stock returns leaves you well enough off to live comfortably.
• Include bonds in your asset allocation unless you are young or rich.
Unless you fit the exceptions above, have some bond funds. Even if you are young and rich, it’s OK to have bonds, but it is not a necessity.
• Among your stock holdings, have some foreign stocks, including both developed and emerging countries.
It may feel risky to invest in foreign countries, but it’s actually riskier not to invest overseas. The stock markets of other countries sometimes (though not always) go up when the United States market goes down, or sometimes go down when the American market goes up. As a result, a blend of U.S. and foreign assets will be more stable than either one individually.
By the same token, emerging markets (the poor countries) and the developed markets (rich countries) sometimes move in separate directions. So even though stocks of countries in emerging markets (like Vietnam, Indonesia, and Malaysia) are risky by themselves, they can reduce your overall portfolio risk.
Emerging markets stocks also have higher average returns, historically, so you can get paid to reduce your risk. That is very cool.
Looking deep into the future, I expect emerging country stock markets to be more integrated with developed countries’ markets. Then their stock returns won’t be much higher than ours, and they won’t often go in different directions from our markets. At that time, diversification into these foreign stock markets will not be of much benefit. Until then, diversify.
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Lesson 1: What the Heck is a 401k, and What’s So Great About It?
Lesson 2: Contributions to Your 401k
Lesson 3: Investments “Cook Book” Approach
» Lesson 4: Investments: How Investments Work
Lesson 5: Loans and Hardship Withdrawals from Your 401k
Lesson 9: Your 401k, Your Other Assets, and Your Life
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