Investing inside your 401k
Posted Oct 30, 2019
If your employer offers a 401k plan, then you have undoubtedly been confronted with picking different investment options that are available in the plan. A frequent question I get when talking to people is how they should be investing inside their 401k plan? This is an important question that can either help or hurt your plans for retirement. While everyone is unique in both their age, risk tolerance (how much volatility can your stomach handle), risk capacity (how much volatility can you afford to handle), and financial goals (how much income do you need at retirement), there are some good rules of thumb. The younger an investor is, the more risk they are able to take. This is because the young investor has a large amount of human capital (i.e. future earnings) and can afford to have riskier assets since they may still have up to 40+ working years to continue earning wages. The older an investor gets, the less human capital they have in their portfolio, and therefore have less ability to take on investment risk since the majority of their working years are behind them.
The Pension Protection Act of 2006 allowed 401k providers to start using Target-Date Retirement Funds as the Qualified Default Investment Alternative (QDIA). This was a huge improvement for 401k participants because it provided a simple, set it and forget it mutual fund to choose. The Target-Date Fund is designed to incrementally change it’s allocation from nearly all stocks to a mixture of stocks and bonds as the fund gets closer to its target year. So if an investor doesn’t know what to do or doesn’t make a selection, then the Target-Date Fund that coincides with your retirement age is a fantastic option.
Without the proper guidance and know how, investors can get themselves into disastrous situations by deciding to chase returns by continually moving funds into the highest performing funds. The problem with this method is that by the time you make the change, the fund has already achieved its major gains and is likely to underperform going forward. This is why I’m a fan of most investors sticking with Target-Date Funds inside their 401k. While it’s far from perfect, the Target-Date Fund does ensure the investor is well diversified globally across all asset classes and maintains a disciplined investment approach.
However, if an investor has investments outside of the 401k, these assets need to be coordinated with the 401k. Having funds in different types of accounts allows the investor to focus on asset location, instead of just the typical allocation and diversification discussion. This allows the investor to still maintain the proper diversification and asset allocation, but they can implement more tax-efficient strategies among their investments.
Unless an investor is working with an advisor or has a strong understanding of investing, Target-Date Funds are a strong choice inside their 401k plan.
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