For most participating in a company 401(k) plan, it can be difficult to confidently create a portfolio that aligns with one’s financial goals and objectives. The challenges vary from the confusion around expenses to the limited menu of stock and bond mutual fund options; not to mention the illusion of diversification. So how do you make sense of your options and construct a portfolio you can have confidence in? Below are a few steps to help get you started!
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Start with Asset Class Allocation
To determine the appropriate stock-to-bond ratio within your 401(k), you must first establish goals for wealth accumulation. For most, the primary goal is accruing enough money to maintain a confident lifestyle after retirement. So, what is considered “enough money?” That answer varies based on an individual’s retirement plan. To help understand what that means for you, here is a three-step process to follow:
- Determine your annual spending and then adjust for inflation to determine what the inflation adjusted number will be at retirement (*Recommendation: Use a minimum of 2% inflation adjustment for each year between now and retirement).
- Determine how much cash flow you can expect from sources, such as pensions, social security, etc. at retirement.
- Subtract #2 from #1 and then divide this number by 3.5% or 0.035 (*3.5% is a solid withdrawal rate goal on your accumulated retirement principal). The resulting number from this calculation is the amount of money you need to accumulate before retirement. Now, based on reasonable rate of return assumptions and assumptions about how long you intend to work, you can determine the asset allocation required to achieve your long-term accumulation goals (*Recommendation: 8% for stocks; 2% for bonds/fixed income/cash).
Diversify Within Asset Classes
Once asset class allocations are determined, look to diversify within those asset classes. For stocks, look to expand your exposure across US Large Cap, Mid and Small Cap, International, and Emerging Market stocks. Be sure to look to your time horizon, also known as the timeline for when investors plan to gain value in their investments. It is important to make sure you are more focused on managing downside risk the closer you are to retirement (See below for help with risk determination).
Understand Risks and Expenses within Asset Classes
One of the easiest ways to determine how much risk you are taking in your investments is what is known as “Beta.” Beta is an indicator of relative risk to the broader market, which has a Beta of 1. If a fund/stock has a Beta greater than 1, it involves greater statistical risk than the broader market. Inversely, if Beta is less than 1, it involves less statistical risk than the broader market. A quick internal look at each investment option should provide you with the Beta for each investment option. If you have trouble finding it, contact your plan custodian (i.e., Schwab, Fidelity, etc.) and ask for help. Finally, it also makes sense to evaluate the underlying expense ratios of your various investment options. This analysis may bring to light less expensive investment options with better historical performance. While analyzing these expense differences is an important factor, it shouldn’t be your primary driver of your investment decision.
Managing a 401(k) can seem very daunting, but it is well worth it to reach your financial goals by retirement. If you have any questions on how to get started or how to improve your portfolio, consult with a Financial Planner to help you work towards your goals.
Marshall Clay CFP, J.D., is a Partner and Senior Advisor at The Welch Group, LLC, specializing in providing Fee-Only investment management and financial advice to families throughout the United States. Marshall is a graduate of the United States Military Academy in West Point, New York, the Cumberland School of Law in Birmingham, Alabama, and is a CERTIFIED FINANCIAL PLANNER™. In addition, Marshall is a frequent guest on local television stations as an expert on various financial planning matters.
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