401(k) Tips and Tricks

Flavors and Combinations

Reviewing 401(k)’s is like visiting an ice cream shop. There are so many flavors and combinations you can get and making a decision may not be easy. I’ve provided a few 401(k) tips and tricks to help you figure out the right investment allocations.

Assessing Risk Tolerance

For those of you who don’t know where to begin, I recommend answering some kind of risk tolerance questionnaire. There are several you can find using Google, but if you want ours, please contact us.

The risk tolerance questionnaire gives you a good starting point on how you should allocate your 401(k). If you are more aggressive, you need to allocate a greater percent of your money to stocks. If you are more defensive, you need to allocate more of your money to defensive options (I’ll touch on this more later). If you scored right down the middle, the traditional allocation for a balanced portfolio would be 60% stocks, and 40% bonds.

Personal Circumstances and Market Conditions

Once you have a rough idea of how much you should be invested in stocks from your risk tolerance, you need to adjust that by 2 factors:  your personal circumstances (i.e., age, income needs, savings, college funds, etc.) and current market conditions.

If you are younger and/or have a long way from retirement, you should consider bumping your stock allocation higher. If you expect to withdraw money from your 401(k) in 5 years or less, you should consider lowering your stock allocation.

You should also consider how much money you save on a monthly basis, how much you spend, and how large your liquid net worth is. These factors are more complicated, so they are outside of the scope of this blog post.

Finally, you should adjust your stock allocation up or down based on market conditions. If the market is greedy (markets at or nearing their 52-week highs), lower your allocation to stocks. If the market is panicking (markets trending down), be aggressive.

Detailed Tips

What I have outlined above is something everyone should think about when conducting their annual 401(k) reviews, but there are few more tips that a more experienced investor may want to give additional thought to (the more novice investor can skip this part and go to the Final Key Thoughts section):

Instead of allocating money to a target date retirement date fund (one with a year in the fund name such as Vanguard Target Retirement 2055), you can go to Morningstar and look up the stock allocation and copy the general allocation yourself. Make sure that you diversify amongst the different stock asset classes (US Large Cap, US Mid Cap, US Small Cap, International, and Emerging Markets). The reason you are going through all the trouble to allocate outside of target funds is that target retirement funds have 2 layers of fees: the fee for the target fund and the fee for each of the underlying funds. By taking this step, you are eliminating one layer of fees. While the amount you save may not be large in the short term, it could add up in the long term. Every dollar counts.

The defensive part of your 401(k) should not always be in bond funds. If you think interest rates are headed higher, your best option could be a money market or stable value option. At WealthArch, we advised our clients to stay away from bond funds prior to 2022, and that decision turned out very favorably when a lot of bond funds were down significantly in 2022.

The Big Portfolio Picture and Hypothetical Examples

When reviewing your 401(k), don’t just review it in isolation. I highly recommend looking at your liquid net worth as one whole pie in order to make thoughtful and deep decisions.

Younger, More Aggressive

When reviewing your 401(k), don’t just review it in isolation. I highly recommend looking at your liquid net worth as one whole pie in order to make thoughtful and deep decisions.

The typical 401(k) doesn’t have the best stock investment options. If you are young and have investment accounts other than a 401(k), it is better to allocate the stock portion outside of the 401(k).

For example, a couple has a liquid net worth of $500,000. Their risk tolerance questionnaire says they have a balanced risk tolerance. After making adjustments for their specific situation (young) and market conditions (stocks are cheap), they decide a 75% stock allocation is right for them.

If they have $125,000 in their 401(k)’s and $375,000 in IRAs and taxable brokerage accounts, they should allocate all their stocks outside their 401(k) because their investment options are significantly more outside of a 401(k). For the defensive portion of their allocation, they can use the 401(k) for that because either a stable value fund or bond fund should suffice for their needs.

Older, More Conservative

The typical 401(k) also doesn’t allow you to invest in individual bonds. If you are older and/or retired and have investment accounts other than a 401(k), it is better to allocate the bond portion outside the 401(k) in an IRA or a taxable account.

In a rising interest rate environment, bond funds will decline in value. In contrast, an individual bond, as long as it doesn’t default and you hold it until maturity, has no interest rate risk. Under these 2 conditions, you will get all of your principal back plus interest.

Because the defensive part of your portfolio is more important when you are older and/or retired, I think it’s better to have the stock portion of your overall allocation invested in the 401(k)’s. In this scenario, index funds like those that mirror the S&P 500 for your stock allocation should be good enough.

The Big Portfolio Picture and Hypothetical Examples

There are so many things to consider when reviewing your 401(k) allocations, but if everything I have said above is too complicated, let me leave you with a few key thoughts:

1. Save money and invest in your 401(k), especially if your employer gives a match.
2. If you ever change jobs or retire, rollover the money in your 401(k) to an IRA, so you can increase your investment options exponentially.
3. I’m going to expound on one of things I said earlier, if the market is greedy, lower your allocation to stocks. If the market is panicking, be aggressive.

One caveat for this advice is that you should not practice extreme modifications to your strategic asset allocation.

I recommend a +/- 20% band to your overall stock allocation. If your strategic allocation to stocks is 60%, don’t go below 40% and don’t go beyond 80%.

Also, make changes gradually, not something like a 20% change in one shot.

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