If your employer offers it, a 401(k) is a critical tool in saving for retirement. Approximately $4 trillion of savings are invested in 401(k) accounts, according to Investment Company Institute retirement data.
Even if you’re saving enough, it can be hard to choose the right 401(k) options to build a comprehensive retirement portfolio, because there’s no one-size-fits-all solution due to the ranges of ages and risk tolerances of 401(k) investors.
There are some bad choices out there — but also some good ones. Employer stock is generally a bad choice. Diversified low-cost funds are usually good choices, combined correctly. Here, we offer four simple rules to get you on track with your 401(k)
Rule 1 – Avoid Holding Any Employer Stock in Your 401(k)
Holding stock in your employer is risky because you’re already taking a big bet on the company just by working there. You’ve already invested your paycheck and future earnings growth in it, so why throw in your savings?
Individual stock picking, no matter what the company, can be risky at the best of times. An individual stock may fall much more than an index fund that tracks a broad selection of diversified stocks.
Single stocks will always be more volatile. In any given year, some will lose half their value, but indexes hardly ever come close to seeing those kind of declines, according to Robert Schiller’s historic stock market data. Even though employer stock is an option on many plans, it’s a choice best avoided when building a diversified portfolio.
Rule 2 – Under 50s Should Hold Most of Their 401(k) in Stock Funds
If you have at least 15 years until you need the money, which is the case for most people under 50, you need exposure to stocks. While they may have bad years, they tend to outperform other asset classes over the long run. Those returns will add up.
Historically, U.S. stocks have returned about 6 percent a year, which means you double your money every 12 years. Of course, for that growth you have to be able to tolerate occasional years of double digit declines. History has shown that markets tend to rebound and attain new highs after such painful declines, just as they have since the last recession.
Depending on your age and risk tolerance, if you’re under 50 and can tolerate some bad years in exchange for relatively high overall returns, consider having 50 percent to 80 percent of your 401(k) in stock funds, starting at the high end and declining as you age.
Rule 3 – Get Additional Asset Classes and International Exposure
Though stocks do well long term, holding bonds can help when markets tank. When stocks do poorly, bonds often continue to grow, or at least decline less. Most portfolios diversify by holding both stocks and bonds.
Exposure to other asset classes, such as inflation-protected securities and real estate, hedges your portfolio, though finding good options within 401(k) plans can be difficult. That’s why it’s important to look at your portfolio as a whole, and compensate in other accounts where possible
Adding international exposure also helps diversify as different countries rise and fall at different times. So look for funds that have a global allocation rather than those limited to the United States.
Rule 4 – Pick Fund With Low, Low Fees
The fees that funds charge can differ by a factor of 10, from as low as under 0.1 percent per year to well over 1 percent.
Small differences in fees will translate into large differences in your pot of retirement money. In the vast majority of cases, low fees lead to better performance, according to Morningstar research. The cost of a fee creates a performance disadvantage from the start, and most funds never overcome it. Cheaper funds that track an index tend do better than a more expensive active funds trying to beat it.
Putting This Into Practice
Look through your 401(k) selections. Be extremely cautious with employer stock, but do expose yourself to stock funds, ideally diversified, international ones. Add diversified, low-cost bond funds to manage risk in bad times. Include some exposure to real estate and inflation-protected securities where available. And finally, pay attention to annual fees and pick the lowest-fee funds wherever possible. All this should take no more than an hour or two, and it can dramatically improve your chances for a comfortable retirement.
Simon Moore CFA, MBA, is chief investment officer at the award-winning retirement service FutureAdvisor. FutureAdvisor provides an online service to analyse and improve upon your retirement savings choices. It only takes a few minutes. Get your free analysis at www.futureadvisor.com.
More from Manilla.com: