Sound Strategy for your 401(K)
The 401k Plan
Despite what you may think, a 401k plan is not an investment. It is a tax-advantaged retirement savings account into which you (and sometimes your employer) make pretax contributions. You use the money you contribute to the 401k to purchase different investments that are offered by the plan. Most 401k plans offer workers a variety of investments, the most common of which is the mutual fund.
Mutual funds are well suited for 401k plans because they are diversified -- they invest in many securities. Long-term investors, such as retirement savers, usually want to diversify their portfolios because it helps smooth out their returns by reducing investment risk -- the fluctuation in an investment's value.
Choosing a Fund
How do you select the best mutual fund for your 401k?
The task may seem daunting -- especially if your 401k offers a lot of funds. But, most 401k plans offer funds that hold securities from one of three general asset classes: stocks, bonds and cash. Some funds hold a mix of stocks and bonds and are called balanced funds.
Like screwdrivers and hammers, each of these investment types, or asset classes, is made for a specific job. When you have the right mix, it becomes easier to build your retirement.
If you read the prospectuses of all the funds offered in your plan, you'll soon see that many of the offerings are really variations on a theme. After about an hour of prospectus reading, that hammer may come in handy. For instance, a small-cap fund or an emerging growth fund are both stock funds, but they only hold specific types of stocks. To get a broad representation of the stock market, you may need to buy several funds or look for a more general fund among your offerings.
With a stock mutual fund, your reward is based on the performance of all the securities held by the fund rather than of a single stock. Most mutual funds (stock, bond or cash) select investments according to a stated investment goal and strategy, contained in the mutual fund's prospectus.
Figuring out what kind of fund you are being offered isn't always easy. Sometimes the fund name says what assets it holds, sometimes not. In either case, it's a good idea to look at the fund's prospectus and read the investment policy, which will be specific.
For instance, the popular Vanguard 500 Index fund's objective states: "the fund seeks to match the performance of a benchmark index that measures the investment return of large-capitalization stocks." To put it simply, this fund invests in the largest stocks traded in the U.S. It attempts to match the performance of the Standard & Poor's 500 index, a stock market benchmark.
Some funds may invest primarily in growth stocks (shares of companies poised to grow rapidly in the near future) or value stocks (stocks of firms that are mature and whose assets outweigh their liabilities). Other funds specialize in stocks of small companies (small-cap), medium-size companies (mid-cap) or large companies (large-cap). Some, called international funds, invest in overseas companies.
A bond fund invests primarily in bonds, which are basically a loan to a corporation or government. When you buy a bond you become the lender. The bond seller agrees to pay you interest and to repay the amount you loaned it by a certain time (the maturity date). Bonds typically mature in two to 30 years. Bonds are less risky than stocks, but not entirely without risk. One reason: a rise in interest rates can cause bond prices to fall, thus reducing the value of your investment.
Rather than putting its eggs in the basket of a single bond, a bond fund invests in many. The fund profits from the interest payments it receives on the bonds it owns and by selling bonds whose price has risen.
As with stock funds, bond funds come in different flavors. Some funds only invest in U.S. government bonds, which are the safest in the world. Others invest in bonds issued by corporations, which can be pretty safe. A common reason why investors buy bond funds is to provide stability to their portfolios. Some funds invest in high-risk corporate bonds, called junk bonds, which provide less stability and a higher potential return along with their higher risk.
A cash investment, such as a money market mutual fund, typically invests in short-term debt securities, such as certificates of deposit and U.S. treasury bills that mature in one year or less. Because the probability of repayment of these securities is high, when you invest in a cash security, it pays very low interest rates and tends to have the lowest risk of any investment. Cash securities are designed to not increase or decrease in value.
You generally don't want to buy only one mutual fund. In most cases you want to invest in at least several, to diversify your mutual fund holdings. One exception would be if you invest in a lifecycle fund, which contains a pre-set mix of stocks and bonds geared toward your age, and is designed to be the only fund in which you invest.
Company Stock
Many employers offer company stock as a matching contribution to their 401k plan and/or as one of the plan's investment choices. Company stock had advantages and disadvantages. For most retirement savers it has one big disadvantage that outweighs all the advantages: it is a high-risk investment, simply by virtue of being an individual stock (as opposed to a mutual fund).
If you have a large chunk of company stock in your 401k portfolio, you are taking a big bet on your company. If your employer does well, so will your stock. But, if your company falters, as Enron and WorldCom did, your retirement portfolio could be at great risk.
Investment Risk Tolerance
Bonds, stable value and cash may seem like the best options because they have low risk. But, low-risk investments, with their corresponding low returns, may not provide you with a comfortable retirement. Stocks historically have given the highest potential return over the long term.
What's the best mix of investments? The answer is different for each person.
Before picking funds, you need to create an investment strategy based on your savings rate, your age, your retirement date, retirement goals and your tolerance for investment risk. Risk tolerance is your ability to tolerate a loss. How you would feel if your retirement portfolio fell by 10 percent, 20 percent or more? Assessing your risk and choosing appropriate investments is of monumental importance. You will be glad you devoted the time to the task.