How Should I Invest My 401(k)? Q&A with Patrick Doherty, CFP®Submitted by Reby Advisors | Certified Financial Planners | Danbury, CT on February 18th, 2019
By Patrick Doherty, CFP®, February 19, 2019
A 401(k) plan is the most common retirement vehicle available for working professionals in the private sector, giving employees a way to reduce their taxable income and save for retirement at the same time. It’s also a great way to ensure a disciplined savings strategy: The employer directly deposits a portion of each paycheck into the retirement account.
For nearly everyone who works at a company that offers a 401(k), it’s a good idea to take advantage of it. However, whether to participate in the plan is generally the simplest and most obvious question. Deciding how to invest is more complex.
CERTIFIED FINANCIAL PLANNER™ professional Patrick Doherty discusses common 401(k) investing mistakes and answers frequently asked questions below:
Which funds should I invest in?
The funds available differ greatly from one 401(k) plan to the next, but one thing everyone should focus on is their asset allocation. Be as diversified as possible by investing in different funds that expose you to different asset classes.
By “asset classes”, I’m referring to the size of the companies in the funds (i.e. large cap vs. small cap), growth stocks vs. value stocks, whether the fund invests domestically or internationally, stocks or bonds, and so on. You do this because you want to capture the full gains of the market and reduce the risk of being overexposed to the asset classes that perform poorly during a given time period. Oftentimes, when large cap stocks have a down year, for example, small caps perform well.
Below is an example of a portfolio that is diversified across multiple asset classes.
So what you do is you look at the individual funds available to you, see what asset classes they expose you to, and as much as possible, avoid duplication. Cast a wide net.
Should I invest an equal amount in every asset class in order to diversify?
As a rule, no. In the pie chart above, you can see that our asset allocation is weighted towards large cap funds over mid cap and small cap. That’s because large companies make up a greater percentage of the total value of the stock market than smaller companies.
Also, depending on where you are in your wealth building and retirement plans, you are likely to want a higher percentage of your investments in equities than fixed income.
I’m getting close to retirement. Should I invest in all fixed income funds?
Generally, no. Many people believe that as you approach retirement, it’s so imperative to protect the value of your assets that you need to eliminate all risk. There are a few problems with this:
First, what you really need in order to sustain your lifestyle through retirement is for your assets to not only generate enough income for this year, but to grow so that your income keeps pace with rising prices. Unless you’re extremely wealthy, fixed income probably won’t achieve that. If you need $100,000 to live your lifestyle this year, five years from now you’ll need $115,000 to live that same lifestyle.
Second, you don’t need all of your nest egg the first year in retirement. You probably only need 4% or 5% in that first year, or 12% to 15% in the first three years. That’s the money you really need to protect.
You can afford fluctuation in value for the assets you’ll need 10, 20 or 30 years down the road, because with that volatility, historically, comes growth that keeps pace with rising prices. Over time, markets have always gone up. Remember, a loss in value is only a loss if you sell low.
Should I invest in a target date fund?
I’m hesitant to recommend target date funds because I rarely agree with the asset allocation in those funds. They tend to be too conservative and lack growth potential, especially as the investor approaches retirement.
When I review a client’s target date fund options, what I’ll often do is recommend a later target date than the actual retirement date. For example, if the investor plans to retire in 2030, I may recommend the 2040 or even the 2050 target date so that the portfolio contains the right level growth potential to achieve their income goals.
Everyone’s situation is different and target date funds vary, so this isn’t a recommendation. However, that’s typically what I find after investigation.
Should I invest in an asset allocation fund to ensure diversification?
The idea behind an asset allocation fund is that many investors have neither the time nor the expertise to build a properly diversified portfolio, so they create one fund that supposedly contains all the diversification you need.
The idea is a good one, but the execution is often poor. These funds frequently exclude important asset classes, track other asset classes poorly or have higher fees.
My 401(k) includes the S&P 500 index fund. Is that enough diversification?
The actual diversification within the S&P 500 index is frequently overestimated. It sounds like you’re diversifying across 500 different large cap stocks, however, it’s a weighted index. This means that when you invest in an S&P 500 index fund, you’re investing heavily in very few stocks whose market capitalizations make up a high percentage of the index.
According to Seeking Alpha, as of July 2018, the top 5 stocks had a market capitalization equal to the bottom 282 stocks. If you’re invested too heavily in the index, you’re overexposed to these five stocks.
Should I always choose the funds with the lowest expense ratios?
Focusing on expense ratios at the expense of asset allocation can be a mistake. Outside of a 401(k), when you have thousands of options, it almost always makes sense to seek funds with low costs; there’s no correlation between high fees and high returns. Within a 401(k), however, your options are limited. It’s usually more important to ensure you’re diversified and have exposure to multiple asset classes than it is to try and cherry pick funds exclusively with the lowest fees.
Should I always contribute the maximum amount?
I almost always recommend investing at least the amount your employer matches. Otherwise, you’re passing up free money.
However, I don’t always recommend maxing out a 401(k) because there are other considerations beyond immediate tax savings.
Once you’re retired, for example, your 401(k) or IRA distributions are taxed as ordinary income, whereas withdrawals from non-retirement accounts get taxed as capital gains at a lower rate. Having a balance between the two types of accounts gives you the flexibility to manage your tax bracket in retirement by strategically choosing which accounts to draw income from. For this reason, it may be worth it to invest a portion of your savings into a non-retirement account, depending on your situation.
Another consideration is that you may have other goals that take precedence. Do you need to save for education or build up for your emergency fund? Retirement may be the most expensive goal on your list, but it’s not the only one.
If you have additional questions about how to invest in a 401(k), we’d love to hear from you. Write to firstname.lastname@example.org or call (203) 790-4949.