A lot of 401(k) investors end up making the same
mistakes when choosing their investments. The
results are low returns and unbalanced portfolios.
Avoiding these four mistakes is a good start for
getting more out of your 401(k).
There is no easy answer to how you should allocate
your 401(k). You have to make these decisions on
your own based on your personal risk tolerance,
investment choices and the allocation of your other
Mistake #1: Going overboard on risk avoidance
Many 401(k) plan participants are either overwhelmed
by the list of investment choices or are simply afraid
to take any risk in their investments, and so put all of
their savings into a money market or stable value
fund. Sometimes the money market fund is the default
option for their employer’s plan -- meaning their
money ends up there, earning very low interest.
Nobody bothers to change it.
Money market and stable value funds are basically
fancy words for cash, a low risk, low return
investment, and the return from cash usually lags
behind inflation. This means that a 401(k) in these
safe investments will probably decline in value over
time. For many folks, the investment horizon is long,
so you can tolerate some volatility to get the higher
Mistake #2: The equal allocation trap
Another common mistake made by investors in their
401(k)s is to invest an equal portion into each
available investment option. This is called the 1/N
There are many problems with taking this approach.
First, you do not need to invest in every option
available in your plan. Especially now that target date
retirement funds (mutual funds that change allocation
based on your estimated retirement date, growing
more conservative as you age) have become popular,
you do not need to invest in every bond fund and
every stock fund to achieve diversification. Also, each
investment option has been selected based in its
individual characteristics, not based on how all of the
options work together.
Your employer is not suggesting that you should
invest in every option, and certainly not in each
equally. Every plan has a different investment line-up.
For example, let’s say your company has one money
market fund, one bond fund, and eight stock funds.
An equal investment into each fund results in an
overall allocation of 80% stocks, 10% bonds, and
10% cash, a pretty aggressive portfolio. The
employer’s intent is not to encourage each participant,
regardless of age, risk tolerance, and time to
retirement, to have an 80/20 allocation.
Mistake #3: Too much company stock
Many companies allow employees to purchase
company stock in their retirement plans. As tempting
as it might be to bet on a company you know very well
(hey, you work there, right?), you should minimize
your investment in company stock. Remember Enron,
Bear Stearns and Lehman Brothers? Those
employees lost their jobs and their retirement savings
in one day when their companies went bankrupt.
If you are going to be laid off from your job, your
company is probably in trouble, and its stock will also
be low. Why would you want to bet your income and
your future retirement on one company?
Investments in diversified bond and stock mutual
funds will reduce this risk. As a rule of thumb, keep
your investment in company stock below 10% of the
Mistake #4: Eschewing small-cap and international stocks
When you enroll in a 401(k) plan, your employer
should provide you with the recent performance of
every investment option in the plan. Most investors
are naturally risk-averse, and shy away from
investment options that have been down recently.
The performance of small-cap and international
stocks has been less than domestic large-cap stocks
recently. But these funds are still excellent choices for
increasing portfolio diversification. They have
characteristics that can improve the overall returns
and lessen the volatility of your portfolio.
Remember, risk and return are directly related. Don’t
rule out investment options based on past
performance alone. You might want to consult with
your employer’s human resources manager or
whoever manages the company’s benefits plan for
help choosing the best allocation.
Or another smart move: Hire a financial advisor, who
can help you figure out which mix is right for you.
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