Commons Mistakes to Avoid in Your 401k Plan
How should I invest the money in my 401k plan? I hear this question often from clients and prospects.The answer is different for every individual depending on their financial objectives, risk tolerance, investment choices, and the allocation of their other investments. Some companies provide a risk tolerance questionnaire to help participants determine an asset allocation, while even luckier participants can attend semi-annual or annual enrollment meetings with the plan’s “financial advisor”. But the vast majority of 401k plan participants must make these decisions on their own, resulting in some less than desirable investment outcomes.
Here are a few common mistakes made by 401k plan participants:
1. Selecting the Money Market or Stable Value Option – Many 401k plan participants are either overwhelmed by the list of investment choices or are simply afraid to take any risk in their investments. As a result, they opt to put all of their savings into the money market or stable value fund. Sometimes the money market fund is the default option for participants who do not choose another allocation, so many end up with the money market by default. Money and market and stable value funds are basically fancy words for CASH. Cash is a low risk / low return investment, and the return from cash has historically lagged behind inflation. This means that an investment in cash will be worth less in the future after accounting for the rate of inflation. For many 401k participants, the investment horizon is long (you cannot withdraw the money without paying penalties until age 59 ½), so most of you will need to invest in assets with higher expected returns.
2. The 1/N Rule - Another common mistake made by investors in their 401ks is to invest an equal portion into each available investment option. For example, if there are 10 total investment options, the participant invests 10% into each of the options. This is called the 1/N Rule. There are many problems with taking this approach. First, you may not need to invest in every option available in your plan. Especially now that Target Date Retirement Funds have become popular (mutual funds that change allocation based on your estimated retirement date – ex) Fund 2020, Fund 2030, Fund 2040), you do not need to invest in every bond fund, every stock fund, AND every Target Date fund. Secondly, each investment option has been selected based in its individual characteristics, not based on how all of the investment 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. Company A may have: 1 money market fund, 1 bond fund, and 8 stock funds. An equal investment into each fund would result in an overall allocation of 80% stocks, 10% bonds, and 10% cash, a pretty aggressive portfolio. The employer’s intent when selecting the investment options was not to encourage each participant, regardless of age, risk tolerance, and time to retirement, to have an 80/20 allocation.
3. Too Much Company Stock - Many companies allow employees to purchase company stock in their retirement plans. As a result, participants in these plans tend to have very large investments in their company stock. 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. More than likely, if you are going to be laid off from your job, the company 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 total account.
4. Not Investing in Small Cap and International Stocks – When you enroll in a 401k plan, your employer usually provides you with the recent performance of every investment option in the plan. Depending on the recent overall market performance, this information can lead to different decisions made by the investor. Most investors are naturally risk-averse, which means they want to avoid risk as much as possible. Investors will shy away from investment options that have experienced large negative returns. At the moment, the funds whose recent past performance tend to have the largest negative returns are small cap and international stocks. International and small cap stocks are excellent choices for increasing portfolio diversification (the “don’t put all of your eggs in one basket” or three baskets, theory) and have characteristics that can improve the overall returns and volatility of your portfolio. Remember, risk and return are directly related, which means you MUST take most risk to get a HIGHER return. Don’t rule out investment options based on past performance alone.
Now that you know the common mistakes, you may still be wondering how YOU should invest you 401k portfolio. Unfortunately, there are no “one size fits all” answers. You can start by determining your overall target allocation to cash, stocks, and bonds. You may have an HR manager or “financial advisor” available to you through your company. You can also hire a financial planner, who charges an hourly or flat rate fee, to help you with the decision.