According to the Investment Company Institute there were over 55 million active participants in 401(k) plans plus millions of former employees and retirees as of the end of last year. The amount of money is staggering at $5.3 trillion as of the end of 2017.
With the demise of traditional defined benefit plans, 401(k)’s provide the most popular way for individuals to save for their retirement. 401(k)’s are also the second largest source of US household wealth right behind home equity.
Given the importance of 401(k)’s to US household financial health you would think that plan participants would watch their balances like a hawk and actively manage their holdings.
Some people do, but the vast majority of people do not truly understand what they own or why. Most people know that the more they contribute to their 401(k) the higher their ending balances are going to be, but beyond that there is a lot of confusion.
Many people do not make 401(k) choices naturally. Many participants do not even know where to begin when it comes to:
When given a choice, people usually start with the issue or problem that they perceive as the easiest to figure out, not necessarily the one of greatest importance.
Many people approach the problem of how to invest their 401(k) in a simplistic manner.
Many 401(k) participants start off by selecting funds. For most participants this is not an easy choice, but in comparison to the other issues this one appears manageable.
But sadly, participants are getting it backwards by picking funds first. They are not framing the problem correctly.
Picking funds before figuring out your goals and objectives is like picking furniture before you know the size and shape of your dining room. It might work out but it would involve a lot of luck. Do you want to count on luck when it comes to your financial future?
A different way of addressing the challenge is to start the other way around. Start with the end goal in mind. Reframe the problem to first figure out what you are trying to do.
You want your 401(k) to work for you and your family, right? Sound like a better starting point?Without knowing what you are trying to do and what really matters to you putting money into your 401(k) loses meaning.
First figure out for yourself why you are taking money out of your paycheck to put into your 401(K). What is your “why”?
The answer may be obvious to you, but when money gets tight due to some unforeseen life event you will be glad that you have a tangible picture for its ultimate use.
Visualize what you are going to do with that money. Is it for a retirement full of adventure? Is it for buying that dream sailboat that you’ll take around the world? Or, is it simply to preserve your lifestyle once you retire?
Money has no intrinsic value if you don’t spend it on things that matter to you and your family.
Richard DeVos, Founder of Amway
Money cannot buy peace of mind. It cannot heal ruptured relationships, or build meaning into a life that has none.
If starting with the end in mind makes sense to you, let's take a look at the four steps to take now to make your 401(k) spring back to life.
Hint: Start With the End in Mind
Outline your main financial and life goals
Determine the level of risk you need and are willing to tolerate
Set your allocation between stocks, bonds, and cash
Pick your funds from the plan sponsor menu
Outline your main financial and life goals
Visualize your goals and objectives for the type of life you and your family want to lead. Don’t just think about your retirement – think as broadly as possible.
Close your eyes, visualize, pour a nice glass of cabernet for you and your partner before you have the “talk”, write it down in your journal – whatever approach gets you out of your everyday busy persona and makes you focus on what you really want out of life.
How do you want to use your money to accomplish this lifestyle? Maybe you and your spouse want to engage in missionary work in 10 years. Maybe you also need to fund college expenses for your children? Maybe you see a lakefront house in the near future? There is no cookie cutter approach when it comes to people’s dreams! It’s up to you to make them up.
Your 401(k) assets are just one component of your household wealth. Think about your other assets and financial obligations. And don’t forget to include your partner’s or spouse’s.
Your house, your emergency fund, investments in mutual funds, possibly a little inheritance, company stock. Almost forgot, your spouse’s 401(k) and that condo that he/she bought before you met. Take a comprehensive inventory of your assets.
How much debt do you have? That is part of your financial picture as well. Do you anticipate paying your mortgage off in the next few years?
Wealth managers talk about a concept called the household balance sheet. It’s the same idea that financial analysts use when evaluating a company. In the corporate world you have assets, liabilities and the difference is net worth. In your own world you have assets, obligations and unfunded goals, and net worth is the difference.
Sounds a bit harsh when it involves you, right? Don’t take it personally. The key idea is taking an inventory of what you own, what you owe and then matching that up to your goals and aspirations.
Determine how much risk you need to take and are comfortable with
The whole idea of saving and investing is about making your goals and aspirations a reality. If you already have enough assets to fund your desired lifestyle into perpetuity then you don’t really have to worry too much about investing. Just preserve what you got!
If you are like most people, you need to make your investments work for you. You need a return on your assets.
It’s a good idea to be realistic about goals and objectives.
- Are your goals reachable?
- Are your financial and life goals aligned?
- Are your goals consistent wit the vision you have for your life?
Your answer will dictate how aggressive you will need to be in your investment strategy. The more ambitious (financially speaking) the goal the more you will have to reach for high returns.
To some extent this is the easy part.
There is a link between risk and return in the capital markets. Higher risk usually translates over long periods of time into higher returns. Equities do better on average than bonds and bonds in turn do better than money market investments. So far so good.
Figuring out the required rate of return to fund your goals and objectives given your resources involves math but little emotional contribution.
But what about your emotions?
This is the tricky part. Many people are able to conceptualize risk in their heads, but are entirely unable to deal with their emotions when they start losing money.
They think of themselves as risk takers but can’t stand losing money. They panic every time the stock market takes a dip. It does not matter why the market is tanking – they do not like it and run for the exits.
But an honest assessment of both your need to take risk as well as your comfort level with investment fluctuations is necessary in managing your long-term financial health. You will see massive cracks if these two dimensions of risk are not aligned.
Let’s examine a simple situation where we classify your need and comfort level with investment risk in three states: low, medium and high.
The table below lays out the possibilities.
Ideally, your two dimensions of risk will align. For example, if your need for risk is low and your comfort level with taking risk is low you are all set. Same if you need a high risk/high return strategy to meet your goals and objectives and you are comfortable experiencing significant fluctuations in your portfolio. Your need for risk and comfort are aligned!
Needs to be Conservative
Needs to be Aggressive
Low Comfort with Risk
LIVING IN FEAR
LIVING IN FEAR
High Comfort with Risk
The real problem is when the two dimensions of risk are not aligned.
You’ll need to resolve any differences or misalignments as soon as possible to regain any hope of financial health.
Let’s say you are really risk averse. You fear losing money. Your worst case scenarios (visions of you becoming a bag lady, eating cat food) keep popping up in your nightmares. If your goals and objectives are ambitious in relation to your resources (high need for risk) those nightmares will not go away and you will live in fear.
You can do one of two things – learn to live with fear or, scale back your goals and objectives. There is no right or wrong answer – it’s up to you but you must choose.
What if you are comfortable taking on lots of investment risk? Would you like a low risk/low return portfolio? Probably not. In fact, such a portfolio would probably drive you crazy even if you did not need higher returns.
People comfortable with investment risk frequently suffer from fear of missing out (FOMO). They think that they should be doing better. They want to push the envelope whether they need to or not. It's part of their personality - they want more, more, more.
FOMO is as damaging of an emotion as living in fear. Both states spell trouble. FOMO should not influence your investment decisions.
Life is about balance. Investing is no different.
Balance involves figuring out how much risk you need to take versus how comfortable you are with taking that risk. Balance does not mean never taking risk but rather taking an appropriate amount of risk given your situation and goals.
Set your asset allocation mix(split between stocks, bonds and cash)
Sounds like a mouthful, right?
Let’s put it in plain English. First of all, the term asset allocation simply refers to how much of your investment portfolio you put into the main asset classes of stocks, bonds and cash/bills.
Sure, we can get more complicated than that. In our own research we use ten asset classes, but in reality breaking up the global equity and bond markets into finer breakouts is not critical for the average individual investor.
Figuring out the right range of stocks, bonds and cash is much more important than figuring out whether growth will outperform value or whether to include an allocation to real estate trusts. Be patient - do the micro fine tuning later once you have figured out your big picture asset allocation.
Let’s look at some possible stock/bond allocations. We'll focus on risk and return.
We are going to use information from data provided by Professor Aswath Domodaran from NYU. It covers US annual asset returns from 1928 to 2021. We are using the S&P 500 for stocks and a medium credit quality (Baa) portfolio for bonds. For cash - the safest asset - we use the 3 month US t-bill.
The top half of the table shows the performance and volatility of stocks, bonds and cash by themselves.
Stocks are the riskiest but also have the highest average return. Cash is the safest but does not yield much, on average. With historical inflation running, on average, about 3% there is not much real return in cash investments. Finally bonds are in between. They carry some risk because companies may go bankrupt and default on their debt but, in general, they are much safer than stocks.
From year to year there is tremendous variability in returns but for the sake of simplicity you can use historical risk and returns statistics as a rough guide.
Here are a couple additional points mentioning
Finally! Go ahead and pick your funds from the lineup in your 401(k)
Yes, this is typically where people start.
Many times people pick a bunch of funds based on a friend’s recommendation or simply based on the brand of the investment manager. Rarely do people dig deep and evaluate the track record of funds.
A lot of people pick their funds and declare victory. They are making a huge mistake. They are not framing the problem correctly.
The problem is all about how to make your 401(k) work for you in the context of your goals and objectives, your resources and your comfort with investment fluctuations.
Picking funds is the least important part. You still have to do it but first figure out what matters to you, your need and comfort with risk and your target stock, bond, cash mix.
Once you have your target asset allocation go to work and research your fund options. Easier said than done, right?
Here are some fund features that you should focus on.
Understanding what makes a good fund choice versus a sub-optimal one is beyond the financial literacy and attention span of most plan participants.
For most people a good rule of thumb to use is to allocate to at least two funds in each target asset class.
Let’s make this more concrete. Say your target asset allocation is 60% stocks and 40% bonds. Most 401(k) plans have a number of stock and bond funds available.
What should you do?
A minimalist approach might entail choosing an S&P 500 index fund and an actively managed emerging market equity fund placing 30% in each. This maybe appear a bit risky to some so maybe you only put 10% in the emerging market fund and 20% in a US small capitalization fund. The key point is that having more funds is not always better!
Same on the bond side where you might allocate 20% to an active index fund tracking the Bloomberg US Aggregate index and 20% in a high yield actively managed option.
Let your fund research dictate your choice of funds. You should keep things simple.
Know what funds you own and why. Keep your fund holdings in line with your asset allocation. Spreading your money into a large number of fund options does not buy you much beyond unneeded complexity.
Most of your 401(k) performance will be driven by your target asset allocation anyway.
Picking funds that closely match the risk and return characteristics of your asset classes (say stocks and bonds) is good enough. Trying to micro-manage the selection of funds will not likely lead to a huge difference in overall portfolio returns.