This post is part three of three in the 401(k) Series:

  1. Deciphering the Traditional 401(k)
  2. Do you like free 401(k) contribution money?
  3. Choosing funds for your 401(k)

We’ll follow a three-step process for choosing your 401(k) investment options:

  1. Decide on an overall asset allocation, for all accounts
  2. Review your plan options and eliminate a wide swath
  3. Apply your asset allocation to your 401(k) investment

Decide on an asset allocation

Your asset allocation overall

Before you dig into your 401(k) plan materials, you need to establish an investment plan for all accounts.

Allocation percentage formula:

Combine every IRA, Roth IRA, Simple IRA, SEP IRA, HSA, 403(b), RESP, 529, Brokerage, etc… that you have or plan to have in your investing lifetime.From a macro level, you should be able to establish an overall allocation for your portfolio. To keep matters simple, we’ll only look at stock/bond allocations in this article. There’s room for REIT’s and direct real estate ownership in future discussions.

For stock/bond buckets, traditional advisors have argued for an age-based rule as a starting point: 100 minus your age = your % of stocks. So a 20-year-old would have 80% of all assets in stocks. Recently, advisors have shifted more aggressively and recommended that the starting number (100) be higher, between 110 and 120. At its most aggressive, this would result in a 20-year-old having 100% stocks, 25 having 95%, and so forth.

Your Risk Tolerance:

These are indeed good starting points, and you should adjust the starting number (100 – 120) based on your risk tolerance; higher risks means a higher starting number. Your risk appetite comes completely from your self-knowledge.

How would you react if your $250,000 shrunk to $125,000 in the course of a year? Would you sell those dirty rotten stocks and park your remaining balance in oh-so-safe cash? If you’d even consider the thought, then your risk tolerance is pretty low. A 50% paper haircut is within the realm of expectations for any stock investment. If you’re not mentally prepared to stick out the low points and/or you don’t have time to wait out a nasty recession, then you have no business being in 100% stocks no matter what a formula says.

Final answer

At this point, you should have a gut feeling for your preferred allocation. If you’re older or closer to retirement, you’re probably thinking around 30/70 to 60/40 stocks/bonds. If you’re younger and full of confidence, you’re more of the 90/10 mindset, maybe even higher. Hold on to these numbers for a minute while we look at 401(k) plans specifically.

Keep in mind that up until now, our allocation discussion has been limited to a top-level view of all of your liquid assets, and now we’re going to look at a very specific plan, a microcosm of your overall picture. As Dukes of Dollars, we need to put some more thought into what’s going on with allocations for two big reasons: your accumulation timeline and investment tax placement.

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Your asset allocation inside of a 401(k) plan

The multiple steps of a 401(k)

It’d be so simple and easy to take the number you had in the previous section, apply it to a few funds, set up automatic reallocation, and move on to your day.

In fact, feel free to do so; it’ll turn out just fine. However, you’d be leaving money on the table by ignoring your accumulation timeline.

To get a better idea of the progression of your wealth building, head over to the roadmap. You’ll see that 401(k) plans make a couple appearances: [Step #4] Contribution up to company match and [Step #10] Max out 401(k) contribution.

You don’t start accumulating taxable accounts until [Step #12], and it takes most Dukes a solid 5-10 years of great earnings to reach that point. Unless you’re chasing six figures in the beginning of your financial plan, maxing out your 401(k) annually is a difficult challenge.

The key takeaway from this realization is that your 401(k) contributions from [Step #4] and [Step #12] have an earlier birth date than your other investments.

The life cycle of your 401(k)

Not only is your 401(k) money “early money” in that you make the first contributions when you’re quite young, but a mature 401(k) is also “old (wo)man money” in that it’s harder to get your hands on it for spending before the age of 65. Whereas Roth IRA contributions and taxable accounts are always available for spending, and HSA’s are always be available for medical expense reimbursement, to get access to your 401(k) money without paying painful penalties and taxes, you have to jump through complicated hoops. That means you’d be best off leaving it to accumulate in its 401(k) or Rollover IRA status for a long time.

The life of your 401(k) dollars begins early and ends late. It’s the first money you sock away and the last money you spend. Therefore, it has a long life. Funds that have a long time-frame should be invested ultra-aggressive, much more so than an “overall allocation” formula would suggest. At Duke of Dollars, we like to go against the grain when it makes sense, and here’s a doozy for all you finance professionals to scream about in the comments: inside of a 401(k) we recommend no less than a 90/10 stocks-to-bonds allocation for anyone who is > 5 years from retirement.

Tax placement should be considered!

While the accumulation timeline argument makes a strong case for our bold recommendation, there’s another factor in play: tax placement. Holding tax-free municipal bonds in a 401(k) doesn’t make any sense. The account is already tax-advantaged, so you’d be giving up interest basis points for no reason. Likewise, growth stocks with little-to-no dividend payments would be better served in taxable accounts so that you can harvest losses and only realize capital gains when your taxable income is low enough to secure minimum capital gains taxes. Investments that feature aggressive risk profiles or have high taxable income should have consideration for your 401(k). You can place safer assets elsewhere, later in your wealth building timeline.

Review your plan options and eliminate a wide swath

So what should go inside your 401(k)?

  • Stock index funds
  • High-yield bond index funds
  • REIT index funds
  • Treasuries or money market funds

Why funds charge fees:

Notice a pattern? The words “index funds” are in three of the four categories. This is intended to reduce expenses. Major financial companies love 401(k) plans because they make up an enormous pool of money to be “managed” for annual fees. We’re talking about $25 TRILLION dollars in 401(k) assets as of 2016. Human brains can’t even fathom what that number means, it’s so big.

Twenty-five trillion seconds is about 800,000 years.

So when a fund can charge an extra .001% of its assets under management (AUM), it really moves the needle – in favor of Fidelity, T Rowe Price, or whomever your company’s preferred provider happens to be. These expenses eat into your returns, taking small amounts each year in a theft you can envision as erosion. That erosion might not seem like much over a few months, but how did the Grand Canyon form? Erosion. Don’t let fees create a canyon in your portfolio!

Eliminate high fee options:

Review the funds available in your 401(k) plan. Eliminate anything with an Expense Ratio >= 0.75%. If you are left with nothing, schedule a meeting with your plan administrator to explain that your options are too limited and too expensive. This is a person in your company, probably HR, who is in charge of negotiating with the plan provider. They are capable of changing the plans available for your investments, but they won’t make any changes unless you speak up. In the meantime, begrudgingly raise that Expense Ratio until you end up with 5 – 10 plans that are expensive but will have to suffice.

Make your final picks!

Hopefully, after applying the Expense Ratio filter, you’re left with more than a few options. Now, cross off anything that says “tax-free” or “municipal,” eliminate any funds that operate based on your age or expected retirement date (“target date”), and get rid of anything that sounds related to commodities or super specialization. You’re looking to end up with a low-cost fund in each category: Large Cap, Mid Cap, Small Cap, REIT, Treasuries/money-market, and High Yield Bond.

Apply your asset allocation to your 401(k) investments

Now you have an Overall Asset Allocation and a list of potential funds. You need to adjust your Overall Asset Allocation into your 401(k) Asset Allocation.

This means having a good idea of what your balance sheet looks like outside of your 401(k). For example – if you’re planning to retire within a year, there’s a strong chance that you have substantial balances in a taxable checking/savings/brokerage account. Are those assets invested conservatively because you plan to spend them within 5 years? They should be. Not every account will be split according to your overall asset allocation. With the summation of the parts roughly matching your asset allocation, some accounts may be entirely bonds and others entirely stocks. Your 401(k) should veer toward the latter.

It’s a good idea to keep a small percentage of bonds or treasuries to take advantage of automatic and free rebalancing offered by most 401(k) plans. This feature kicks in on a regular basis, quarterly or annually, and reset your allocation by selling assets that have grown and purchased assets that have grown less (or shrunk).

That puts a “buy low / sell high” machination on your account without resorting to the much-maligned concept of market timing. Most importantly, after you’ve set up your account, don’t look at it often. It’s going to swing wildly during the many years that you own it. The less you know about the balance, psychology studies show, the better your assets will perform. You won’t be tempted to “lock in gains” when the market rises or, heaven forbid, panic-sell during a collapse. Just ride it all out, trust your allocation and rebalancing, then see where you are as you approach retirement.

Thank you for reading – you have officially completed step IV of our roadmap!