How to Invest Your 401k: A Generic Guide.

So you finally got a job with a 401k. The only problem is: what on earth are all these choices and what am are you supposed to do with them? The Armchair Fiduciary will try to answer that question for you in this brief guide to investing your 401k.

There are some ground rules. First, this guide assumes you are 40 or younger (i.e. you have a long time horizon before you need the money). Second, as is mentioned in my profile, I am not a professional financial planner. What is offered here is merely advice on how I personally would invest my 401k. You should follow this advice at your own risk. So without further adieu let's get on to the guide.

1) How Much Should One Contribute?

This is probably the first decision you will make. The simple answer is you should contribute as much as you can afford up to the maximum allowable contribution ($15,500 in 2007, $16,000 in 2008). I would put 401k investment when you are young only behind food and shelter for your family in terms of priorities.

Why? First, Social Security should be in dire straights by the time people who are young today retire. If it still exists as it does today the taxes will have to go way up (which won't be popular). If the benefits are changed it will be hard to predict what those changes might be and how they will affect your payout. The bottom-line is that the conservative approach is to assume Social Security will not be there (even though it probably will be in some shape or form). Second, savings in a 401k are tax deferred meaning that you pay income tax on the money as you withdraw it instead of when it goes in. You get to capture compound interest tax free until you withdraw money at the end. The time value of money makes this a valuable feature. There has been some debate in the popular press about whether 401ks are a good deal because current tax rates on capital gains in normal taxable accounts are 15% for long-term gains while income taxes run in the 20%+ range for most of us. I simply don't believe that long-term capital gains can stay as low as they are forever so I think over time these thing should roughly equal out (i.e. capital gains should return to the 20%+ zone by the time we retire). Even excluding that, if you ever sell any assets in your taxable account to switch into a different investment Uncle Sam takes 15% of whatever gains you have. In a 401k you can change your mind on investments without tax penalties because you only pay out taxes when you withdraw from the account. Third, many employers match a percentage of your 401k contribution. Passing on this is a little akin to volunteering to take a pay cut. Finally, I like 401ks because there are tax penalties for early withdrawals (before age 59.5). This may seem counter intuitive, but with a taxable account the money is too easy for most of us to get at. The 401k plan, because it comes with strings attached, enforces discipline and generally makes us think twice about stealing from our retirement cookie jar.

2) How Should I Split My Money Between Stocks (a.k.a. equities) and Bonds?

Generally while you are young I would encourage investing most of your 401k in equities. In fact, I personally would put the whole thing in equities. The reason is simple. Over the long-term because equities are riskier they produce higher returns. The whole point of the retirement account is to fend off inflation and then some and equities have a strong history of doing that. While US Treasury bonds are widely viewed as a "risk-free" bet, you "pay" for taking less risk by getting lower returns. Because you aren't going to touch your 401k for 20+ years you can afford to weather a few down years in the stock market. Plus, if the market tanks you are going to continue contributing to your 401k so you will buy stocks while they are "cheap". Now portfolio theorists will say I am guiding you off the capital markets line which maximizes risk adjusted return (i.e. get the maximum return for a given level of volatility). My answer to them is that on average you will want a higher level of equities if you have a long time horizon and that an average investor is unlikely to successfully calculate the optimal mix of asset allocation.

3) So How Should I Invest my Equity Portfolio?

a) To Index or Not to Index?

While I am a firm believer that there are some money managers out there that can beat the market with stock selection, I am not a firm believer that the average 401k will offer you access to many (if any) of those managers. If the plan offers index funds you should most likely go with those. If not, then you should try to find funds with low expense ratios, good long term returns, and total assets of less than $5 billion. This information can usually be found easily on Yahoo Finance. Just go to "symbol lookup," punch in the name of your fund, and then look at the "profile" and "performance" pages. You want a fund that on the profile page has net assets less than $5 billion (fund managers have a hard time outperforming if they manage too many assets in my opinion) and an expense ratio at or below the category average. On the "performance" page you want a fund that has a longer term history of beating their benchmark and peer group. If the "diff" category is a positive number that means the fund beat its peers in the category or benchmark.

b) International vs. Domestic Equities?

I think the most important decision you are going to make is the mix between US and foreign equities. I personally would divide my account into about 50% US equities and 30% developed foreign equities and 20% emerging market equities. Developed nations include most of the EU and Japan a complete list can be found here. The other 20% should go into emerging markets like China, India, Latin America, Eastern Europe, etc. A list can be found here. The reason I think you want a lot of foreign assets is simple. I am pretty confident that the balance of economic power in the world is shifting. 20-30 years from now I think China, India, Russia and others will likely have a bigger role in the global financial system than they do today. That's why I want to encourage people to invest abroad as well as in the US. I think some of the best investment opportunities in the next few decades will be abroad. Furthermore, US equities only account for about 1/2 of the world market capitalization. Owning more than 50% US equities is a bet that US equities will outperform the rest of the world and that is a bet that I don't want to actively make. Why not underweight the US? First, I think the US will hold its own during this time of economic change. Second, if you are US citizen you are going to consume your retirement in US dollars. It makes sense to have a large portion of dollar denominated assets since those are what you will need when you retire. If you had all international securities you would also be making a bet that other countries currencies appreciate against the dollar. I'm no currency expert so a 50/50 mix of dollars and foreign denominated assets makes some sense to me so you have some protection no matter what currencies do.

c) Small, Mid, or Large Cap Stocks?

I would try to get a roughly equal mix of all three of these. That means if you are looking at indexes you want something that is either a total market index (e.g. Russell 3000) or you want to own 1/3 in indexes that mimic the Russell 2000 (small cap), 1/3 in the Russell midcap (mid cap), and 1/3 in the S&P 500 (large cap). When you are making international investments you are unlikely to be able to choose an index based on market cap size. I put the mix of domestic versus international above the market cap mix in this guide because I think it is more important. If you don't have cap choices internationally in your plan I wouldn't be surprised. If this is the case don't worry about it. Just invest internationally anyway.

d) Growth vs. Value?

Growth investors try to find stocks that have great growth prospects, but tend to be a little more expensive on various financial metrics. Value investors try to find stocks that are undervalued even if the company doesn't have great growth prospects. Both strategies can work well at different times. Some academic studies have shown that value strategies tend to work better over long periods of time than growth strategies. I'd generally do a mix of about 33% growth and 66% value. I think this is one of the least important decisions you will make when allocating your 401k. You should only care about value versus growth if you don't have an index fund option to invest in.

4) Should I ever borrow from my 401k?
No! That's not what it is there for. There are exceptions- if you have a medical emergency or something and the choice is borrow from your 401k or use credit cards then you should tap into the 401k, but for the most part your 401k is OFF LIMITS!

5) I left my job, what should I do with my 401k?
In most cases you should roll it over into a traditional IRA because they offer you a lot more choices than 401k plans and are still tax deferred. Be sure to do a trustee to trustee transfer to avoid tax problems when you do the roll over.

6) Help, I am still confused!
If you are still confused or find that this information is too generic for your needs or you are over 40, don't hesitate to email me and ask more specific questions. I'm happy to look at your specific plan options and tell you what I would do. If you email a really good question be forewarned that I might turn it into a post though I will keep you 100% anonymous. Note: if this post hits the front page Digg or something it might take me a long time to respond. I do promise to try to respond to each email even if it takes a while.