I have had a 401(k) for many years now and often field questions about the best way to manage these accounts.
For all its flaws, I do love the humble 401(k). It there is a match, I always contribute up to the maximum match. If you don’t, you are effectively throwing away free money. It’s a bit like your employer offering you a 3% raise, for instance, and you declining the offer! At my previous employer, 4% of the contributions were matched, dollar for dollar. That is a 100% return on investment (ignoring returns of the underlying investments). I don’t know anywhere else that you can consistently earn this type of immediate return. Your gains are also not taxed every year (tax-deferred), so every dollar that you gain grows, without being reduced by annual taxes.
We have all heard the expression “don’t put all your eggs in one basket.” You are protecting your total portfolio if one or two of your investments go south. I prefer the so called naïve diversification, or 1/n (1 over n) diversification, as it is also called. If you have the option on five different asset classes, you split your contributions five ways and invest in each option. This way you avoid guessing which asset classes are going to do better or worse over your investment horizon. It is important to check that the assets in your five different mutual funds that you choose do not overlap, since this could sink your portfolio if the overlapping assets under-perform.
Once a year I rebalance my portfolio. Say, one of my funds has grown to 30% of my portfolio and one of the options has dropped to only 10% of my portfolio (remember, we started at a 20% even split), I would sell some the funds that have done well and buy some units the under-performing fund until I get back to 20%. This is the secret to making money in the stock market: Buy low, sell high. I have effectively taken profits on the fund that has done well and bought the funds that have done badly at a better price, lowering my cost basis, or “averaging down”, as it is often called. “Averaging down” on individual stocks may not be a good idea, since the stocks may become worthless while you’re buying more, but for an asset class, like bonds, for instance, it is very unlikely to end up worthless.
How do you choose the best options? I prefer index funds. They have the lowest fees and by their very nature you are guaranteed to perform as well as the market. Think this is not great? Seventy percent of managed mutual funds under-perform the market. I prefer the 100% chance of doing as well as the market. If you don’t have the option of index funds, choose the asset class mutual funds with the lowest cost. For instance, you can choose a “Large Cap” mutual fund as one of your options.
Do not invest too much of your 401(k) contributions in company stock. I recommend 5%, at the most. Thousands of Enron employees have lost their entire retirement portfolio, because they were too heavily invested in their own company stock. The criticism normally given for not investing in your own company stock is that you already depend on the company for your monthly income. If your company goes bankrupt, yo will lose both your job and your retirement investment. The proponents of investing in company stock argue that you have an informational advantage in that you know better than most whether your company is doing well or not and that you can gain from your hard work as part of the team. A good example would be Microsoft employees who have becoming millionaires owning Microsoft stock. It is important to understand, though, is that this is very rare.
A 401(k) can be a very important part of your retirement mix and can provide you with the income that you need to have a satisfying retirement. Look after it and it will eventually look after you.