Foolproof Ways to Allocate Your 401(k) Money
Choosing the right 401(k) allocation can be easy with these options.
Investing your 401(k) money in a way that is best for your long-term goals is harder than you might think. If you are not sure what to do, that is perfectly normal!
Here are three foolproof ways to allocate your 401(k) account, and a fourth way that might work if the first three options are not available.
1. Use Target Date Funds
The term "target date" means your targeted retirement date. You’ll know your 401(k) offers a target date fund when you see a calendar year in the name of the fund, such as T. Rowe Price Retirement 2030 Fund. Target-date funds make long-term investing easy. Decide the approximate year you wish to retire, then pick the fund with the date closest to your target retirement date. For example, if you plan to retire at about age 60, and that will be around the year 2030, pick a target date fund with the year "2030" in its name.
A target date fund spreads your 401(k) money across many asset classes such as large company stocks, small-company stocks, bonds, emerging-markets stocks, real estate stocks, etc. It automatically chooses how much of which asset class to own. Once you pick your target date fund, there is nothing else you need to do.
As you near the target date, the fund progressively becomes more conservative, owning less stocks and more bonds. The goal is to reduce the risk you are taking as you near the date where you will need to begin withdrawing from your 401(k) money.
2. Use Balanced Funds
A balanced fund allocates money across both stocks and bonds, usually in a proportion of about 60% stocks, 40% bonds. In times when the stock market is quickly rising, you can expect that a balanced fund will not rise as quickly. In times where the stock market is falling, expect that a balanced fund will not fall as far.
If you don’t know when you might retire, and you want a solid approach that is not too conservative and not too aggressive, choosing a fund that has “balanced” in its name will be a good choice. It evens out the ups and downs. You can put your entire 401(k) plan in a balanced fund, as it is maintaining balance and diversification for you. This type of fund, like a target date fund, does the work for you.
3. Use Model Portfolios
Many 401(k) providers offer model portfolios. A model portfolio is based on a mathematically constructed asset allocation approach. The portfolios have names such as Level I, II, III; or Conservative, Moderate, Moderately Aggressive. These portfolios are crafted by skilled investment advisors so that each model portfolio has the right mix of investments for its stated level of risk. Risk is measured by the amount the portfolio might drop in a single year during a down-turn.
Most investors who aren't working with a financial advisor are best served by putting their 401(k) money in one of these models, rather than trying to pick and choose among available funds. Many of my friends send me their 401(k) statements and ask me what they should do. Whenever I see model portfolios available, I recommend they use them. It results in a better, more balanced, more disciplined approach than most people can accomplish on their own.
For those who are working with a financial advisor, rather than using a model portfolio, the advisor is likely to pick the funds for you to use in a way that coordinates with your investments in other accounts. If you are married and you each have investments in different accounts, an advisor can be a great help in coordinating your choices across your household.
4. Spread 401(k) Money Equally Across Available Options
Most 401(k) plans offer some version of the choices described above. If they don’t, a fourth way to allocate your 401(k) money is to spread it out equally across all available choices. This will often result in a well-balanced portfolio. For example, if your 401(k) offers ten choices, put 10% of your money in each.
Or, pick one fund from each category; such as one fund from large cap, one from small cap, one from bonds, one from international, and one that is a money market or stable value fund. In this scenario , you’d put 20%, or 1/5th of your 401(k) money in each fund.
This method works if there are a limited set of options, but doesn't work well if there are over 15 choices.
This last method is not as fool-proof as the first three. When possible, it is always recommended that you complete an online risk questionnaire or consult a knowledgeable investment professional before haphazardly choosing stock investments that may lose you money.