401k Asset Allocation

By Harper Willis

When you roll your 401(k) assets over into a new 401(k) or an IRA you have to leave behind funds and other investments you held in your original plan and choose new ones. That can be a great opportunity to take a good look at whether your old investment plan applies to your current situation—and then make any adjustments that seem appropriate.

If you already have a well-conceived investment plan, then you will know how to make the adjustments you need to deal with changes that have occurred in the financial markets or your own circumstances since you made the plan. But if you’re a bit fuzzy on these matters—like most folks are—here’s a quick primer on how to build a portfolio strategy that suits you.

The first thing to consider is how your assets are divided between stocks, fixed income investments, and short-term investments like cash. To put it in technical terms, you need to review your target asset allocation.

The right asset allocation depends on your time horizon—how soon you’ll need access to the money—as well as your emotional tolerance for taking risk.

In general, the longer your time horizon, the more weighted towards stocks (or funds that hold them) your allocation should be. Why? Stocks tend to generate higher returns over longer periods of time but are more volatile than fixed income investments in the short term. If you have a long time horizon, you’ll be able to wait out temporary dips in the market and reap greater rewards in the long run.

The shorter your time horizon the more you should adjust your allocation towards fixed income securities (or bond funds) and short-term investments such as money market funds. Why? Because if you invest too aggressively and the market takes a temporary dip, you might not have the luxury of waiting until the market recovers before you need access to your funds.

A relatively aggressive allocation strategy might have 70% in stocks, 25% in bonds and 5% in cash. A relatively conservative strategy might have something like 35% in stocks, 35% in bonds, and 30% in short term investments. For most investors, the right mix probably falls somewhere between those two approaches.

Once you choose how to allocate your money between stocks, fixed income and cash, you’ll need to choose from a variety of different assets within each asset class. It’s important to make sure your equity investments aren’t concentrated in one type of stock. Such diversification can protect you from some volatility, since different sectors of the market don’t always move in lockstep.

It makes sense for most investors to hold a sizable stake in large company stocks, with some exposure to smaller company shares. It’s also a good idea to hold some stake in foreign stock markets, often behave very differently from our own stock market.

In the bond market, don’t bet heavily on long-term issues or bonds with low credit ratings; instead make sure your portfolio includes a mix of bonds with different maturities and credit risk.

Whether you’re rolling your money over into a new 401(k) plan or an IRA, mutual funds make it relatively easy to assemble a group of investments that match your target asset allocation. With an IRA, you can choose whatever funds you like. With a 401(k) plan, you’ll be limited to the plan’s choices—but they typically will be adequate to create a well-diversified portfolio.

If you don’t want to manage a portfolio of stock and bond funds, you may be able to invest in a single target date fund (increasing numbers of 401(k) plans offer them). Such funds set up an allocation appropriate for your age, and automatically adjust your asset mix to be more conservative as you approach your target date (usually retirement). You give up some control, including the ability to customize your retirement plan—but actually, that might be a good thing. Many of us are poorly equipped to manage a fund portfolio ourselves, in part because (as many studies show) we tend to buy and sell at the wrong times.

That’s all the more reason to be respectful of your inner demons when you’re deciding on your asset allocation strategy. How vulnerable is your portfolio to a sharp market decline? Will you be able to ride out such fluctuations? Or will you sell when stocks are depressed, thus locking in losses? If you think you might panic in a severe market downturn, take a more conservative approach.

Ultimately, your asset allocation strategy is a very personal matter. The right mix of investments will reflect your personal circumstances and your emotional make-up. Many leading investment firms offer solid asset allocation advice on their websites; check out troweprice.com and fidelity.com for example. If you’re new to this task, spend some time nosing around on such sites, and have a talk with a financial advisor before you make your investment decisions.