A 401(k) retirement plan is one of the most popular ways to
save money for retirement and score some tax breaks for doing so. But often
these plans don’t provide a lot of guidance on how to manage them, and
participants end up with wildly aggressive portfolios, or, what experts often
see, a portfolio so conservative that it barely budges year after year.
Here’s how to see if your 401(k) is too aggressive and, if
so, some steps you can take to fix it.
What is an aggressive 401(k) investment?
When experts speak of being aggressive, they generally mean
how much of your assets are in stocks or stock funds. Stocks are an attractive
long-term investment, but they fluctuate a lot in the short term. That’s
problematic, especially for soon-to-retire investors. If all or almost all of
your retirement account is in stocks or stock funds, it’s aggressive.
While being more aggressive can make a lot of sense if you
have five or 10 years or more until retirement, it can really sink you
financially if you need the money in less than five years. To reduce risk,
investors can add more bond funds to their portfolio or even hold some CDs.
“A large downturn in the market immediately preceding
retirement can have devastating effects on an individual’s standard of living
in retirement,” says Dr. Robert Johnson, finance professor at Creighton University’s
Heider College of Business.
Johnson points to those who retired at the end of 2008 and
who were invested only in the Standard & Poor’s 500 Index (S&P 500),
which contains hundreds of top companies. “If they were invested in the S&P
500, they would have seen their assets fall by 37 percent in one year,” he
says.
But those who had some investments in other assets such as
bonds or even cash would have seen a much lower overall decline. Of course, any
money in the S&P 500 would have declined by a similar amount, but by having
fewer eggs in that basket, their overall portfolio declined less.
That principle of diversification is huge in making sure
that your portfolio is not too aggressive.
But many workers make the opposite mistake, not investing aggressively
enough. If you have more than five years until retirement, and certainly if you
have 10 or more, you can afford to be more aggressive, because you have the
time to ride out the market’s ups and downs.
3 signs your 401(k) is too aggressive
If you think your portfolio might be too aggressive, here
are some signs to look for.
1. Your account balance fluctuates a lot
It can be exciting to see your balance run up quickly, but
it’s important to realize that this could be an effect of a 401(k) that’s
invested too heavily in stock funds and not enough in safer alternatives.
“If you take someone with an account balance of $100,000 and
after one month their account is now $110,000, or 10 percent growth in a month,
what that tells me is that they probably have most of their money in stocks,”
says Matthew Trujillo, CFP at Center for Financial Planning in Southfield,
Michigan.
“This will feel great when things are going up, but that
investor needs to be prepared to see some significant paper losses when we
experience a downturn like what we just saw in March and April,” says Trujillo.
2. You worry a lot about your 401(k)
If downturns in your 401(k) cause you a lot of worry, then
you may be investing too aggressively.
“If someone tends to move out of their investments because
of volatility, then the portfolio is probably too aggressive for them,” says
Randy Carver, president and CEO at Carver Financial Services in the Cleveland
area.
But it’s key to understand that while stocks are more
volatile and you may not always feel comfortable owning them, they are also one
of the best ways to grow your wealth over time, especially in an era of low
interest rates and low bond yields.
“If they are not invested to grow enough to meet long-term
needs, it is too conservative,” says Trujillo. “The key is to look at longer
periods of time, two or three years or more, to see trends, not just one or two
months.”
3. You need cash soon, but your 401(k) doesn’t have any
If you know you’re going to need cash in the next few years,
your 401(k) needs to be factoring that in. That doesn’t mean you need to sell
everything and go to cash now, but you can leave new contributions in cash or
move them into lower-risk bond funds, slowly reducing aggressiveness.
To gauge your plan’s aggressiveness, use the rule of 100,
suggests Chris Keller, partner at Kingman Financial Group in San Antonio. With
this rule, you subtract your age from 100 to find your allocation to stock
funds. For example, a 30-year-old would put 70 percent of a 401(k) in stocks.
Naturally, this rule moves the 401(k) to become less risky as you approach
retirement.
Pointing to the importance of a 70-year-old reducing risk,
Keller says, “Losing half of your portfolio while at this age might have a huge
impact on what your retirement looks like.”
Disadvantages of having a too aggressive 401(k) portfolio
Having a 401(k) portfolio that’s too aggressive can come
with a number of disadvantages, from the annoying to the financially
destructive. Here are some of the most common:
—Your wealth fluctuates a lot. If you’re overexposed to
stocks, your portfolio will bounce around more than it will with less exposure.
That can be ok if you have a long time until retirement, but it’s potentially
much more costly if you’re close to retirement.
—You may need to access your money when the market’s down.
If you’re too aggressive with only a few years or less until retirement, you’re
wagering that the market will stay strong until you tap your money. If it
doesn’t, you’ll have to take distributions in a down market, hurting your
long-term retirement finances.
—A too-aggressive portfolio may scare you out of the market.
The secret to scoring big returns in the market is staying invested. So if a
volatile portfolio scares you out of the market, you lose the key advantage of
investing in stocks.
—Less diversification may mean higher risk. A diversified
stock portfolio can be useful, but if you’re in all stocks, your overall
portfolio may not be as diversified as it could be. So if something negatively
impacts stocks as a whole, your diversification among stocks won’t help you.
—If your portfolio is all stock, then you might not generate
much cash. A portfolio with some bonds or CDs can produce cash, helping you
weather a downturn or allowing you to stay invested in stocks, which usually
show better long-term returns.
Those are some of the largest disadvantages of being too
aggressive in your 401(k).
What you can do if your portfolio is too aggressive
Investors who find their portfolio is too aggressive have
potential fixes for this issue that range from the simple one-time moves to an
overhaul of your financial plan with a financial adviser.
The first step is to take down the risk in your portfolio by
moving some exposure in stock funds (or even riskier options) into bond funds
or even cash, depending on when you need the money.
One good path is to find an asset allocation between stocks,
bonds and cash that meets your needs and temperament. A more aggressive allocation
might have 70 percent or more in stocks, while a more conservative one might
have that much in bonds. Then stick with this allocation and rebalance it when
it moves too far away from your target allocation.
“This means that often a market correction is a good time to
shift more to stocks, not less,” says Carver. “The key is sticking with a
target allocation which eliminates the need to make decisions based on market
behavior or predictions.”
If you’re managing the portfolio yourself, Johnson
recommends starting the risk reduction perhaps as much as five years before
you’ll want to access the portfolio. That doesn’t mean you need to go all cash
and bonds, but rather gradually move the portfolio toward lower total risk.
If you don’t want to make these changes yourself, then use a
target date fund to manage the process for you. It automatically shifts money
from stocks to bonds as you near your target date, which may be retirement, but
could be any time when you need to start withdrawing some cash.
Another good option is to meet with your own adviser and
your company’s 401(k) adviser each January, says Paul Miller, managing partner
at accountancy Miller & Co. in the New York City area.
“It’s critical for an employee to hear what they have to
say,” says Miller. “Take notes and then go to the web and read reviews about
each fund. For example, you can use Morningstar to independently rate and
review your funds.”
Finally, it can be useful to have a financial adviser review
your 401(k), but you must find one who works in your best interest and not one
who is paid to put you in certain financial products. Here’s how to find the
right adviser for you.
Bottom line
“It’s important to note that a retirement date is not the
finish line – even if someone is going to retire at age 60 or 65 the funds
could be needed for another 20-25 years,” says Carver. “They should continue to
be invested in a diversified allocation that has growth potential.”
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