Sunday, January 31, 2010

Investing for Retirement--401k asset allocation

If you have a 401k account you also most likely have mutual funds. But which mutual funds are the right ones to incorporate as part of your retirement account?

Opinions on these questions are probably as varied as there are persons who have opinions to express.

One of the precepts of mutual fund investing is that future performance can be predicated based on past performance. Virtually all mutual fund investment advisers and the mutual fund families themselves provide volumes of statistics relating to the past performance of the particular mutual fund and the rating agencies rate them based on past performance. Although this seems like a logical approach to evaluating a mutual fund, it is based partly on a fallacy. Not completely but partly. The fallacy obviously is that future performance can be based on past performance. The universe just does not work that way. So then what is one to do?

Some of the answer was provided by Harry Markowitz in a paper written in 1952 entitled "Portfolio Selection." His ideas have become known as Modern Portfolio Theory--MPT. Without going into the gory details, the idea basically is that one can reduce risk and increase returns by diversifying ones investments across a wide range of asset classes and rebalancing ones investments periodically. Easier said than done but that is the idea. Mutual funds can play a role.

The role that mutual funds plays in ones portfolio is not and should not be a set and predefined function. It should vary with ones risk acceptance, financial goals, and assets.

Someone risk adverse should not allocate his/her assets into the same mix of mutual funds as someone not risk adverse.

Someone young with his/her future ahead should not invest in the same types of assets as one who is retired.

These concepts should be evident but many times seem not to be. The role mutual funds play in ones portfolio should vary with all the above criteria and more besides.

Generally speaking one has very few other options than mutual funds for ones 401k portfolio other than possibly company stock. The challenge is in determining which mutual funds one should invest in. Recently, the mutual fund industry has attempted to make this decision a no brainer by devising target date retirement funds that reallocate ones investments based on how near one is to retirement. They universally change the asset allocation to a more conservative allocation as one approaches retirement. They also attempt somewhat to rebalance periodically ones assets at least in theory. Among the different mutual fund companies the investments in these target date retirement funds varies, but with 401k accounts one usually does not have a choice among the different families. There generally is only one choice for a particular target retirement date, but one does not specifically have to choose his/her particular retirement date. One can choose a markedly different retirement date which would change the asset allocation mix.

It has been stated as a truism that a younger person should choose a more aggressive asset mix than one nearing retirement. What has not been stated though is how much more aggressive that asset mix should be. Many found in 2000 and again in 2009 that they might have chosen a much too aggressive asset mix as their 401k accounts lost perhaps half of their value and perhaps even more. What seems to be overlooked is that investing for retirement is not a sprint. It is a long distance race. One should invest with that in mind. One should also invest with the future in mind and not specifically based on what happened last year or the last decade. No one really knows for sure what the future might hold. But one can be pretty sure it will not be as the past was. This is where choosing a variety of different asset classes to invest in comes in extremely handy. By spreading ones bets around at least one is not going to suffer a major calamity. Many if not all target date retirement funds tend to concentrate ones investments in what is perceived to be suitable investments but not particularly diversified investments. To illustrate my argument this is the allocation of the Vanguard 2040 retirement fund:

72% Total stock market index fund
10% Total bond market index fund
9% European stock market index fund
4.6% Asian stock market index fund
4.3% Emerging markets index fund

The total stock market index fund consists of over 3400 different stocks. That would seem to be well diversified, wouldn't it? No, it is not. 15.6% of the assets are invested in only 10 stocks. The total bond market index fund is 38% US treasury bonds and 33% US mortgage backed bonds. The same can be said about the other 3 portions of the portfolio. In my opinion this is not as diversified a portfolio as one should have in ones retirement account nor is it as riskless as one might strive for. In other words ones assets might be much much less diversified than one might expect if one is not very careful.

For 401k investors though the task of choosing ones allocation can be a lot more complex than just choosing the no brainer approach. For one thing the company might not even offer a target date retirement account.

So what then would be a decent diversified portfolio for different types of retirement alternatives?

This is my opinion and might vary greatly from the opinion of others. The opinion is based on several premises. First, one should choose a more conservative strategy than a less conservative strategy because these are retirement funds one is investing. Second, one should have a well diversified portfolio because no one knows what the future might hold and it is better to cover the bases broadly unless one has a crystal ball. Third, as one does get closer to retirement the asset allocation certainly should become more conservative but perhaps not as conventional wisdom would suggest. Finally, although one does not know what the future holds, one can be pretty sure it will not be as the past.

For a person in his/her 20s with very little in retirement assets and the entire future in front of them.

A portfolio that is mostly equities certainly is appropriate, but relying entirely on equities (stocks) is not so appropriate as many would suggest. Those who did so during 2006 and 2007 suffered a world of hurt during 2008 and 2009.

A sample type portfolio might consist of the following.

20% 500 S&P index fund or broad market index fund or large cap US fund. These have performed really poorly during the last 10 years but we do not invest based on the past.
15% Europe stock fund
20% Developing market stock fund (remember we are looking towards the future)
15% Small cap stock fund. Small cap stocks tend to outperform large stock funds because they have the potential of faster growth. Again we are looking toward the future.
20% Money market funds. I said we should be conservative.
10% Bond funds.

You will note that the suggested allocation is distinctly different from that suggested by Vanguard. This is a more diversified approach to investment allocation than that suggested by virtually all mutual fund companies. I might also add a more conservative allocation.

A sample type portfolio for someone in his/her mid-earning years 30-45 would be just a tad more conservative.

5% less of option 1 and 5% more of option 5 or 6, preferably 5. Remember we are talking about the future and the US has serious debt problems.

A sample for someone 45-55 again would be more conservative still. 5% less of options 2 and 3 and 5% more each of options 5 and 6.

A sample for someone 55-65. This is where one either is on track for retirement or one is not on track. If one is not on track and does have close to 10 more years, then all is not yet lost, but if one only has 5 or fewer years then safety first regardless. If one of the retirement options is a mutual fund investing in resource stocks--oil stocks, copper stocks, gold stock--this might be a way to make up some lost ground. It would be worth a shot to divert allocations from 1 and 2 into a fund investing in resource stocks perhaps a total of 10%. That does entail some risks though. To become a tad more conservative one should increase ones allocation into money market funds to at least 35% taking from bond funds and small cap funds and emerging market funds.

Finally, how much should be invested in a 401k account. Most companies have a matching amount and one should certainly strive to get the entire match if possible. For many that might be out of reach but certainly get as much as you can. Beyond the match it is not an easy question to answer. A big concern is what the future tax rate might be. Remember that 401k contributions when they are removed are taxed at the full tax rate. It is deferred but not advantaged as it is if one invests in mutual funds outside of a 401k account. In that respect it might be appropriate to consider investments also outside of a 401k account especially with funds that do not have a company match.

2 comments:

  1. Good read. Asset allocation is very hard to get a real good handle on. Most people think that there is a right answer.
    You bring up a good point with the market being down in 2008-2009. Never sell at the bottom. I see too many decide to get out. Take that time as a great time to get in.

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