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How to get better returns from your 401(k)

(MoneyWatch) A few days ago I wrote about the growing use of professional account management by participants in 401(k) plans, which I think this is a very good thing. It shows more people are using professional advice that's designed to protect and grow their retirement savings.

But even so, the majority of people manage their own 401(k) plan account. If this is you, there are some important things you must do each year to help grow your 401(k) account. Here's an action plan for folks who direct and manage the investment allocation in their 401(k) plan accounts.

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Personalize and diversify
The typical 401(k) plan today offers 12 to 18 investment options, which include diversified funds that focus on bonds, stocks of large, mid-size, small and foreign companies. For workers who have a long period of time until retirement, they should consider an allocation of their 401(k) savings primarily in stock funds, because over long periods of time (15 years or longer) stocks have provided higher returns versus bond funds and stable value funds.

Also, since a younger worker will have a smaller 401(k) plan account balance, the primary factor towards increasing their account balance will be contributions and investment risk; the up and down volatility of market values will have a greater chance of working in their favor as they make contributions.

But just allocating your account to a few of the stock funds that recently had the best performance is not proper diversification and doing so can lead to disastrous results. If you loaded up on foreign and emerging market stock funds in 2010 and did not pay attention to your account, then you probably experienced big declines or under performance over the past 12 months in these funds. The lesson here is that you should not only diversify between stocks and bond funds, but also diversify within the asset category, holding large, mid, small and foreign stock funds.

The new 401(k) fund fee disclosures which plans are now required to provide to all participants can provide helpful information to use in this process.

Here is a typical allocation that may be suitable for younger workers who have 15 years or more before retirement.

  • Stable Value and Short Term Bond Funds: 20 percent
  • Large Company Stock Funds: 40 percent
  • Mid Company Stock Funds: 15 percent
  • Small Company Stock Funds: 15 percent
  • Foreign Stock Funds: 10 percent

Reset and rebalance each year
Over time, the riskiest stock funds - which include mid and small cap stock funds - should grow faster than the large cap stock funds and bond funds, and therefore could become a greater proportion of the account's value. This will happen as your account balance grows over time.

Unless you do something called rebalancing, which is a series of transactions that result in resetting your account allocation back to what you originally selected, stocks could become a greater portion of your account over time. In most cases, individuals should rebalance their 401(k) plan account at least once per year with the objective being to maintain their risk level and gradually reduce their allocation to stocks and lower their risk as they near retirement.

Check back in a few days when I'll write about the things people need to do who are automatically enrolled in a 401(k) plan.

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