Nurture Your 401k Portfolio Using Asset Allocation
October 31st, 2008 | Posted in 401k | Edit
Nurture Your 401k Portfolio Using Asset Allocation
Here’s a quick quiz. Which strategy is more likely to help you reach your retirement goals: finding the next hot fund about to rally and investing everything in it, or splitting your money among carefully selected funds, some of which don’t even appear to be winners?
If you answered the latter, you probably have a good idea of what asset allocation is about. If you answered “finding the hot fund,” you need to pay especially close attention to this article.
Free Stock Trade. Trade stocks for free on Zecco.com. The Free Trading Community. www.zecco.com
Asset allocation is a strategy used by long-term savers to
spread their money over several
investment 
Allocation Compromises
In developing your allocation you will have to accept compromises.
The first is giving up potential premium returns and high portfolio
volatility in exchange for consistent better-than-average returns
with lower volatility.
Asset allocation is one of the most important things to do to minimize risk. The idea is to spread your money across a broad spectrum of investments, such as cash, bonds and stocks, that don’t move in synch with each other. Indeed, the more your investments act independently of each other, the better. That way, if one asset goes through a rough time, the other assets support the portfolio.
But that doesn’t mean that if one investment is tanking, you should get out and put your money elsewhere. That’s called market timing and it’s a practice that financial planners discourage.
Bad Timing
Here’s why timing is bad idea. If you bailed out of stocks
today, to catch the next rally you would need the market-reading
skills to figure out when it was starting and then to quickly buy
in. But, reading markets is difficult because they don’t move
in a straight line.
Consider the following statistics. They are based on the following assumption — you invest $1,000 in January 1926 and leave it alone until December 2000.
• If you invested it all in Treasury bills, by December
2000 you would have $16,644.
• If you invested it all in stocks, by December 2000 you would
have $2,562,976.
• If you invested it in stocks, yet missed being in the market
the 40 best months over those 75 years, by December 2000 you would
only have $15,050.
Asset allocation keeps your funds always invested in the market so you participate in rallies as they develop.
Building Your Allocation
This article won’t offer you a single, best allocation.
What’s best depends on your situation. But we can offer
guidance to help build your allocation.
Two issues to consider are your time horizon and
investment-risk tolerance.
Time: The longer until you need your savings, the
more money you will be able to save and the more investment risk
you can tolerate. You can assume more risk because your portfolio
will have time to recover from losses.
Risk: The investment risk we’re talking
about refers to the fluctuation or volatility of returns on your
investment. In assessing your risk tolerance keep in mind your time
horizon, your retirement goals, whether you have the money to take
risk and whether you feel comfortable taking risk.
Allocation Steps
The first step is to set up reserves equal to several months of
living expenses. This money should be used for emergencies such as
temporary job loss. The reserves should be invested in liquid,
low-risk investments such as money market funds, financial planners
recommend.
The next step is to create an investment allocation for your
remaining savings — how much you put into equities, bonds or
cash.
While most folks think of allocating their
retirement
portfolios , many planners recommend you apply this
strategy to the investments used for all your long-term savings
goals, such as a child’s college education or buying a second
home.
Don’t rush creating an allocation because it’s one of the most important decisions you will make.
“For the long-term individual investor who maintains a consistent asset allocation and leans toward index funds , asset allocation determines about 100 percent of performance,” according to the January 2000 Ibbotson study The True Impact of Asset Allocation on Returns.
Many employers don’t offer index funds in their 401k plans, but the lesson remains valid: over the long term, your allocation will have a significant impact on your portfolio’s performance.
In creating your allocation, you will have to balance the risks inherent in each investment against their respective returns. From 1925 through today, cash investments generated average returns of 3 percent a year, bonds averaged a little over 5 percent and stocks averaged about 11 percent.
Cash: In a 401k plan, a cash investment would
be a money market fund. These are considered extremely low risk and
generally earn a small return. With this investment your original
investment is not supposed to fluctuate.
Fixed income: In a 401k plan, this asset class is
represented by bond funds. Many bond funds invest in a mix of
government and
corporate
bonds . These funds typically offer a higher rate of
return than cash-type investments and carry a modest amount of
investment risk.
Equities: Within 401k plans this asset class is
often represented by a myriad of funds. Equities have higher
investment risk than cash or
bond
funds . In exchange for assuming this risk you gain the
potential for higher returns. Indeed, equities are the one type of
investment that, historically, has consistently beaten inflation
over the long term. Retirement savers with a long time horizon
should consider inflation the leading risk they face. That suggests
equities should be a dominant asset in their portfolio.
Free Stock Trade. Trade stocks for free on Zecco.com. The Free Trading Community. www.zecco.com
Most 401k investors aren’t offered a single fund to serve as a proxy for the stock market. Typically, plans offer large-cap, small-cap, growth, value and international funds, and various permutations of these. You will need to create an allocation among these sub-classes of equities. It will be up to you to choose the funds to cover these different sub-classes. Carefully research their holdings by reading the fund prospectus to ensure that you are covering each category only once. If you invest in funds with overlapping assets you risk inadvertently putting too much money in a particular stock class.
You can make up for lost returns by saving more, or saving for a longer time.
When to Change Allocation
The recent market turmoil might tempt you to change your
allocation. Don’t, say financial planners. That’s
market-timing.
Your allocation is a long-term plan based on assumptions about your
time horizon, your savings rates and your goals. Recent events have
probably done little to change those assumptions.
The time to consider changing your allocation is when a major
event occurs in your personal life (such as a major medical problem
or accelerated retirement date) that changes your retirement
outlook. If this occurs, you should run through the same
decisionmaking process you used to develop your asset allocation,
but now using your new set of assumptions.
Even as planners advise against changing your allocation, they do
recommend regularly rebalancing your portfolio. To do this, compare
your current allocation with your original allocation. If
they’re not the same, sell assets that make up too large a
percentage of your portfolio, and buy assets that make up too small
a percentage, to return to your original allocation.
Please visit our site for more Retirement, 401k, and
Insurance information:
www.erollover.com
