When investing your 401k money, it is critical to diversify, where you allocate your investments into different asset classes. In a good 401k you’ll have choices of asset classes among:
- Large US Stocks Index Funds
- Mid-sized US Stocks Index Funds
- Small US Stocks Index Funds
- US Bonds
- Real Estate Investment Trusts (REITs)
- International Stocks
- International Bonds
- Managed Large-Cap Stocks
- Managed Small Cap Stocks
- Emerging Growth Stocks
- Target-Date Funds
- Money-Market Funds
In a bad 401k fund, you may only have a few of these choices, and those that you do have will all be managed funds with big fees (of more than 1%). A great plan may have even more of these choices, although the list above is more than adequate for good diversification.
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Given the choices above, here is how I would typically set up my 401k:
- Large US Stocks Index Funds (15%)
- Mid-sized US Stocks Index Funds (20%)
- Small US Stocks Index Funds (20%)
- Real Estate Investment Trusts (REITs) (20%)
- International Stocks (15%)
- Managed Large-Cap Stocks (10%)
Notice that I have about 25% in large US stocks, 40% in medium and small US stocks, 15% in international stocks, and 20% in real estate. Factors that go into these decisions:
- Sometimes large stocks do better than small and medium stocks. Other times small and medium do better than large. I want to be in both places so that I’m invested in those areas regardless of which is doing best at the time.
- Over long periods of time, small and medium stocks will outperform large stocks. I therefore have slightly more invested in medium and small US stocks (40%) than I do in large (30%).
- I want to have things that may do well when the stock market is undergoing a correction. Real-estate is normally fairly uncorrelated to stock movements (except for 2008, when a real estate bubble cratered the stock market). I therefore have 20% in real estate, which will provide returns almost as good as the stock market over long periods of time since REITs have both rental income and appreciation of property values.
- I have some money in a managed, large US stock fund, simply because the particular funds I have in my 401k have a track record of great investment returns when compared to the S&P500. Normally I would forego these and just invest in index funds since the fees are higher for managed funds and performance is normally about the same as index funds, but so far the managers have shown themselves worth the fees charged in my case.
- I have some international exposure as well. Most of the time, the action is in the US, but during some periods international stocks do better. I always want to be invested in whatever is doing well at a given moment.
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An important aspect if you want to do well is discipline. You need to decide upon your allocations and stick with them through think and thin. At times, it is difficult to stay invested the way I should. For example, in late 2016 with the Brexit and other events, the international stock fund in my 401k has been doing poorly over the last year, while US stocks have been doing well. I was very tempted to drop the international stock fund and just be in US stocks, given the performance.
This would have been exactly the wrong thing to do, however. Since international stocks have been doing poorly, while US stocks have been on a roll, the price of US stocks has been bid-up and international stock prices have dropped and some stocks may be under-priced. We may very well see a shift from US to international stocks as investors look for bargains outside of the US. When that happens, I certainly want to be there.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.