Investment Decisions for Your 401(k)
Over 50 million
Americans are currently owners of 401(K) retirement accounts. If you are one of
them, you expect a quarterly account statement that shows the status of the
account along with other relevant information. You will be asked to come up
with ways to invest the cash and confirm the same from one year to another.
There are several ways you can invest the cash depending on your provider. You
stand a better chance of making a good investment decision if you know the
various ways you can invest the cash.
The 401(k) sponsor in
many cases is your employer. He is the plan fiduciary and is legally
responsible for aiding you in selecting the right investment options and
monitoring the progress of your funds. Many plans offer you up to five
investment options for your cash. However, several offer up to 12 alternatives.
The most common investment products include company stock, variable annuities,
mutual funds, and guaranteed investment contracts. You will also find some
plans offering you brokerage accounts from which you can select a few of the
above investment options. Despite being allowed to plan your investments, some
funds restrict your access to the matched contributions from your employer.
However, many of the employers will follow your investment decisions on the
matched contributions
Types of 401(k) Investments
Mutual Funds
Mutual funds are the
most common type of investment available for the 401(K) investments. This is an
investment where the company pools together funds from different investors and
puts it in specific investment goals. The mutual fund makes money by selling
shares to investors. All the cash collected is then used to purchase short-term
money market instruments, stocks, securities, bonds, and other assets. Most
mutual funds invest in a combination of all these investments. Investors share
gains made by the funds proportional to the amount that they had invested. The
fund managers generally make all investment strategies for the fund.
Company Stock
This option is mostly
available in the public-traded companies. Unfortunately, the menu in many of
these plans includes a fund that you can only use to buy the company stock.
Many employers also encourage their employees to choose this option. This is
because doing so improves an employee’s commitment to the company and helps
reduce employee turnover. The most common motivation for this kind of
investment by employers is allowing
employees to buy stock at a lower-than-the-market price or matching the
investment with more than the employees are contributing. This investment can
be a good decision in the short and middle term if the company stocks are doing
good. However, choosing this as your long-term investment plan is likely to put
your finances to a greater risk of a loss.
Individual Securities
If your 401(k) has a
brokerage window, you have the option of investing in an assortment of
securities that includes bonds, stocks, and other instruments in the money
market. You are in full control of your account. Therefore, you can order
buying and selling of the securities as you wish. This option may be good if
you are good at money-market investments. Given that tax is differed in 401(K),
you are not required to file tax for any capital gains that you make from the
investment. However, if you make any withdrawals from the traditional 401(k)
account, you are required to pay income tax.
On the downside, the
brokerage account charges commissions and fees for every transaction that you
complete at the account. Some mutual funds that you buy using the account may
be a lot more expensive than buying using other ways due to the high fees
charged.
Variable Annuities
Variable annuities
differ from the rest of the products explained above because it comes with an
insurance option. This hybrid insurance product combines several funds with
forms of insurance protection.
Decisions to Make on Fund Allocations
If there are several
options available and you would like to diversify your investment, you must
decide how you will allocate the available funds among various investments.
Consider Target Date Funds
Target date funds
denote the date that you plan to retire. The date is indicated on the
fund. When you take the fund, you are
supposed to estimate the date when you are likely to retire then pick a fund
that is close to that date. Most target-date funds spread your cash across
various assets that include real estate stocks, company stocks, and emerging
markets. The management of the find decides how much of the cash will be
invested in what project and does not require your input. As your target date
nears, the fund gets conservative on the investment decisions it makes to
reduce risk so that there will be cash when you start making withdrawals.
A Balanced Fund also Works Well
A Balanced fund
primary allocates funds on both the stocks and bonds at a ratio of 40% for the
bonds and 60% stocks. The advantage of this allocation is that the investment
is not caught up in the market volatilities when there are rises and falls in
either of the two markets. This option works well for people who are not sure
when they would like to retire. Such people go for investment products that are
not too aggressive or risky and not too conservative as to bring very low
returns. Just like the target date fund,
you do not need to determine your cash allocations as the fund managers would
decide for you.
You can Work with a Model Portfolio
If you do not intend
to use either of the options stated above or none is available, you may
consider going for model portfolios.
These portfolios use a mathematical formula to determine how funds would
be distributed among various assets. Investment instruments are arranged as per
the perceived risk and the rate of returns. Investment professionals construct
the portfolios with each option having the right mix of risks and returns.
If you are not working with any financial
adviser, consider using one of such portfolios to make your investments. The
professionals can help in picking investments according to your risk appetite,
retirement goals, and preferences. You can use such assistance to maximize
returns where your spouse also contributes to a separate 401(k) account.
Portfolios also ensure that you are disciplined in your investment decisions
and are not swayed by the current market forces.
Spread the Funds Equally Across Various Options
If none of the above
options is available for your 401(K) plans, you may adopt a plan to spread out
your investments across various options. This helps achieve a balanced
portfolio. Here is an example, if you have ten available options, you may
invest in all ten at 10% of the funds in each. All you are required to do is to
pick an investment in every option that is on the table. Given that most
categories, such as money market, bonds, or bonds, have other smaller options
within them, you might end up investing between 15% and 20% in every major
category. However, only choose this method when all the other options are not
available.
Conclusion
Your investment
decisions on the 401(k) funds will determine how much you are going to make
with your retirement funds before retirement. Take a critical look at the
available options and pick a plan that balances the return on your investment
as well as the risk involved. The very aggressive markets may have a high return
but high risks too. On the other hand, very conservative decisions may bring
very low returns. Your investment decisions should cut in the middle.
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