What financial strategies should you focus on when investing in a 401(k) retirement plan?
In this article, we continue the conversation, started in Ask a 401(k) Advisor:7 Keys to 401(k) Success - Part 1, to explore the other areas, we feel, are essential to having a successful 401(k) experience.
5. What is Your Risk Tolerance?
There is risk in virtually every activity, meaning it is impossible to eliminate risk entirely from our lives. The best we can do is manage the risk to which we expose
ourselves. I know, for example, that I’m willing to tolerate the risk inherent in crossing the street. I also know that I can manage that risk by looking both directions before I cross. The same is true with investing.
Often, the amount of risk we are willing to toleratechanges as we gain experience. For instance, I have worked with clients who were comfortable investing most, or even all, of their money in a diversified stock portfolio. These were long time investors who had weathered a number of the ups and downs in the market.
When the financial crisis of 2008-2009 hit, however, and they saw their portfolios drop by over 50 percent, their comfort level with risk changed. In some cases these investors insisted on changing their exposure to risk from 100 percent equities (stocks) to 50 percent equities and 50 percent bonds. For them, the very immediate risk of losing even more was so compelling that they were no longer comfortable with that much exposure to equities.
Having more exposure to risk than you can tolerate can be very costly. In this case, it caused the investor to sell at the worst time and lock in their losses. The lesson here is that recognizing your own tolerance to risk is critical. From there, you can create financial strategies that compliment your risk tolerance.
6. How Asset Management Solutions can Benefit Your Portfolio
Investors frequently believe that a winning investment strategy should be aimed at determining when to enter or exit the market. As such, an investor focuses solely on trying to pick winning investments and when to get rid of failing investments. This sort of strategy, which is commonly referred to as “active investing”, presumes that it’s possible to determine in advance which stocks, bonds, or funds will do better in the future.
Setting aside the issue of trading on inside information which is illegal, all the empirical and historical evidence on active trading suggests that the consistent and repeatable success of a strategy such as this cannot be explained by anything more than luck. More importantly, the cost of implementing these strategies can typically result in one to one and a half percent in additional annual costs.
What the evidence also shows is that the long-term strategic approach to investing known as “passive” or “managed investing” typically gives better long-term returns at a lower cost. The key to this type of strategic investing is “asset allocation”.
Asset allocation refers to the selection of different non-correlated asset classes to be included in a portfolio blend that results in exposure to all of the various parts of the market. A portfolio with proper asset allocation would include large growth funds and large value funds, small growth funds and small value funds, international funds, and emerging market funds, as well as some bond funds. The amount invested in each fund, or the blend of them, can be constructed in a way to match the risk tolerance of virtually any investor.
7. Rebalancing: Bringing Your Financial Strategies Back Together
Once you have identified your risk tolerance, properly allocated your assets, created a diversified portfolio that reasonably manages cost, and have consistently contributed to your portfolio over an extended period of time, it becomes important to recognize that your investments will not stand still.
Some of your asset classes will go up in value while others will go down. As a result, the overall risk profile of your portfolio will change. For example, if stocks have done well during the lifetime of your portfolio the percentage of your portfolio allocated to stocks will now be higher than when you first started.
Therefore, the overall risk level of the portfolio has changed. This is why rebalancing becomes necessary. Rebalancing involves selling some of your winning funds to bring their percentage back down to their original target allocation and then buying into some of the lower performing funds to bring their percentage back up to their original target allocation. In essence, this allows you to “buy low and sell high” on an ongoing basis while bringing your portfolio back to the level of risk you originally established for yourself. We believe you should rebalance once per year and do so consistently around the same time each year.
The good news is that once you have thought through each of these seven points and made a decision on what’s right for you, there are times when you will need to revisit these choices in the future. You will have created a long-term investment strategy that is uniquely tailored to your investment needs and risk tolerance level. Long-term strategic investing, in turn, will be the key to your long-term success.
Finally, while it’s easy to make a list of important points to keep in mind when investing, there really is no substitute for long-term experience. Because of this, we believe that making these decisions will be much easier if you find and work with a trusted wealth advisor – someone who understands your unique situation and what you hope to achieve with your 401(k).