Let’s talk about something that many people are aware they should be doing, but they don’t necessarily know why or how: Asset Allocation.
Asset allocation is the concept that we can pick and choose certain investments, combine them and end up with a diversified portfolio which meets our risk and reward goals. “Diversified” is an investing buzz-word, and it essentially means we should combine different types of investments to reduce our overall portfolio risk level.
You have the opportunity to build your own, custom investment allocation inside your 401(k) plan, along with being able to choose pre-built investment allocations. Ideally, you will either build or select your investment allocation based on the rules and strategies you developed when you crafted your Investment Policy Statement (IPS). Used in conjunction with your risk profile, your IPS should be the guiding light for how and where to allocate your investment dollars.
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Two Main Financial Classes: Fixed-Income and Equities
There are two main asset classes to invest in through your 401(k): equities and bonds (fixed income). We’ve covered this before, but to briefly review:
Bond investments are a form of a loan. They will have a stated interest rate and a time period until maturity attached to them. Also, they are usually more conservative, lower-risk opportunities. In a 401(k), a bond investment is usually either a US Treasury, Foreign or Corporate bond. In most normal market environments, bonds typically move opposite of stocks, helping to provide balance & diversification to a stock portfolio. As a trade-off, bonds do not typically increase in value like stocks.
Stocks, or “equities”, are actual shares of ownership in a company. In your 401(k), stocks are available in the form of “Mutual Funds” or “ETFs”. These types of investments are baskets of many different stocks which are either chosen by a professional fund manager or to mimic an index (such as the S&P 500). Equities are typically more aggressive investments than bonds, moving directly up or down in step with the overall market. The equity investor is hoping that the value of his investment goes up over time.
Building A Custom Allocation
If you’re going to build your own custom allocation, it’s important to do so after completing a risk tolerance questionnaire and crafting an Investment Policy Statement. Like any game you’ve played, you’ll have a better experience if you know the rules up front. Don’t wing this.
Your risk tolerance should indicate where on the risk spectrum you fall– somewhere from conservative to moderate to aggressive. When you create your investment policy statement, you’ll ideally lay out the rules which dictate exactly what this 401(k) money is for, how long you have until you’ll need it, and how aggressive you’ll be when investing in the 401(k).
For you conservative investors, its best to stick to an allocation which is anywhere from 0-30% in equities and 70-100% in bonds. You’ll want to focus on US-based investments; if you’d like international exposure it should be a small overall portion of your portfolio and you should concentrate on “developed” markets. Stay away from investments that are “emerging”, “small cap” and “high yield”.
For you moderate investors, it’s best to aim at an allocation of anywhere from 30-60% equities and 40-70% in bonds. You’ll again want to focus on US based investments, but can diversify a moderate size of your portfolio into developed international markets if you desire. It’s ok to use a selection of higher risk investments like “small cap”, “emerging” and “high-yield”, but they should be kept to a minimal overall position within your portfolio.
For you more aggressive investors, you can build an allocation which is anywhere from 60-100% equities and 0-40% bonds. Since you most likely have a longer time-frame, you are building a portfolio which has more volatility because you have lots of time to make up for market swings. You are ok to use US-based or international investments, as well as “high yield”, “small cap” and “emerging” strategies.
Should I do a custom portfolio?
As part of your 401(k) program, JarredBunch has created several “pre-built” portfolios which will line up with the risk tolerance questionnaire you completed. We have mixed stocks and bonds to provide a suitable portfolio for the conservative, moderate and aggressive investor. These portfolios are built using extensive academic research and real life experience.
We hope you find this more useful than 401(k) investment experiences you’ve had before.
In addition to these pre-built portfolios, you’ll also have the option to choose “target date funds”, which are professionally managed baskets of stocks & bonds. Target funds automatically reduce risk as time goes on, decreasing the stock holdings and increasing the bond holdings as you near retirement.
For most people, a pre-built allocation model such as we’ve mentioned above will be easier, more appropriate and less stressful. You will have the assurance that a professional portfolio manager accounted for the myriad of moving parts when constructing the portfolio, and that the portfolio lines up with your risk tolerance.
You may be tempted to invest based on things you hear on the news or from your co-workers; heck, they seem like (and probably are) pretty smart people. However, when it comes to investing, for most of us, it’s better to leave portfolio construction to the pros.