Last Updated Jul 19, 2011 4:32 PM EDT
Investing by Default
But automatically enrolled 401(k) accounts also are invested in a default investment fund. The Qualified Default Investment Arangement for folks who are auto enrolled is a single fund that is typically a balanced fund, a target date retirement fund or a life-cycle fund.
These funds are diversified and include cash, stocks and bonds all inside one single fund. Additionally these funds automatically rebalance the allocation and may gradually reduce the exposure to stocks and increase the allocation to cash and bonds as you near retirement.
But folks who are automatically enrolled into one of these default funds need to know that these are not personalized for your specific situation or needs. For example, if you want to increase your allocation to foreign stock funds, these default funds would not allow you to make this adjustment. Also, if you wanted to maintain a higher allocation in stocks even as you near retirement, these funds would not provide for this either. And there is typically a good reason to want to personalize your 401(k) allocation. One of the best reasons is to make changes to your 401(k) allocation to complement the rest of your portfolio. Say you have a large account invested in bonds and therefore you will want to have a smaller allocation invested in bonds in your 401(k) account.
Also, if you want to personalize your investment allocation in an attempt to increase your returns, you will still need to select from the other funds available in your employer's 401(k) plan.
Alternatively, some plans may automatically hire a professional 401(k) account manager to take control of, allocate and manage the accounts of auto-enrolled participants until they elect to take over the management of their account on their own. This approach does allow for personalization and adjustments while having the oversight and management of a professional investment manager.
Personalized Portfolio Better than Default
The typical 401(k) plan today offers 12 to 18 investment options, which include diversified funds that focus on stocks of large, mid-size, small and foreign companies. Since younger workers will typically 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, or 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. From 1995 to 1998 large company stock funds had the best returns of all stock funds. But since 1999, small and foreign stock funds have outperformed large company stock 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.
Here is a typical allocation that may be suitable for younger workers who are being enrolled in their 401(k) plan account:
Stable Value and Bond Funds: 20%
Large Co Stock Funds: 35%
Mid Co Stock Funds: 10%
Small Co Stock Funds: 10%
Foreign Stock Funds: 25%
Over time, the most aggressive/riskiest funds (Mid, Small and Foreign Stock Funds) should grow faster than the Large Company Stock Funds and Bond Funds, and therefore could become a greater proportion of the accounts value. This will happen as your account balance grows and you get older unless you do something called rebalancing to reset your accounts allocation back to what you originally selected. In most cases, people should re-balance 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 single most important thing folks with 401(k)-style accounts need to do during their working life.