401(k) Emergency: Let's Fix It

Let's face it, looking at your 401(k) statement feels like ripping off a Band-Aid. Let's make sure the pain is just as fleeting.

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Enron's collapse vanquished its employees' nest eggs, drawing a gush of ink from the media and the typical stern talk from government types. But even for those of us who don't work at the Houston horror house, things haven't been so sunny. With the S&P 500 in the red over the past three years and trailing humdrum bonds over that stretch, our former blind faith in stocks seems just that.

At a year-end press conference, a Janus exec joked that his 401(k) had become his 201(k) and many of us could say the same -- particularly if we owned funds offered by that Denver fund shop. Like the mountain of dirty plates and glasses left after a party, cleaning up your battered retirement account might seem daunting. Let's look at four ways you can put it back on track without too much effort or homework.

1. Balance Out Your Portfolio

When you started contributing to your 401(k), you thoughtfully spread your money among funds with different styles. Or you put all your money in the fund or funds that performed best over the past year. Or you just checked some boxes and moved on.

Given the dearth of advice we often get with our 401(k) account, it's pretty easy to muck it up. We're always told to build a diversified portfolio, for example, but rarely shown how to do so.

Using the Wilshire 5000 Total Stock Market Index as a guide, we've mapped out a modest blueprint for a diversified U.S. stock-fund portfolio. We publish this each Monday in our Big Screen Archive, but here it is again. To keep your allocation on target, simply rebalance your portfolio at the end of each year. This won't boost your tax bill because the account is tax-deferred.

What if you've looked on Morningstar.com and found that many of your funds have lousy performance vs. their peers? Check out this story on how to handle that common predicament. We would caution you about the perils of having more than 10% of your retirement account in your company's stock, but after Enron we don't really have to do that, do we?

Solid Funds and How They Fit Together A blueprint for a diversified portfolio -- click on any style for some solid choices
Diversified U.S. Stock Funds
Category	Percentage of a Diversified U.S. Stock Portfolio
Large-Cap Growth	35%
Large-Cap Value	35
Mid-Cap Growth	10
Mid-Cap Value	10
Small-Cap Growth	5
Small-Cap Value	5
Bond Funds/Other Stock Funds
Core Bond Funds
Sector Funds
Foreign Funds
Balanced Funds

2. Raise Your Savings -- and Lower Your Expectations

Over the long term, stocks average about an 11% annual gain, but we got pretty accustomed to far higher returns. The S&P 500 rose at least 20% each year from 1995 through 1999, the best five-year stretch in our stock market's history. Unfortunately, many of us came to expect 20% gains and to actually plan on them.

Those folks have had a rude awakening now that stocks have suffered two down years in a row. Rather than plan on an anomaly, it's always a better idea to be conservative. That means bumping up the amount you contribute to your 401(k) and expecting more modest growth. This will lower your current tax bill if you meet certain qualifications because your contributions reduce your taxable income, and it will give you a better shot at retiring on time.

Raising your contribution just a bit can make a big difference over time. If you contributed $300 per month for 20 years and expected a 12% annualized gain, you'd figure to end up with about $560,000. But if you earned only a more modest 9% each year, you'd be fall short by more than $200,000.

If you'd planned on a 9% annualized gain from the start, however, and kicked in an extra $50 per week, you'd still end up with about $560,000. If you get that surprising 12% annualized return, you'd end up with more than $930,000.

3. Have Index Funds? Use Them!

Not every 401(k) plan gives you the option of investing in an index fund that tracks the S&P 500 or even broader Wilshire 5000 indices, but they all should.

Here's why: Index funds are typically cheaper, more tax-efficient and better performers than most actively managed funds at which a high-paid manager picks stocks he or she likes. While there are funds out there that beat the indices, and small- and mid-cap funds routinely beat them, an index fund is a solid choice for your large-cap core stock fund.

Fewer than four in 10 U.S. stock funds beat the S&P 500 or the Wilshire 5000 indices over the past 10 years, according to Chicago research house Morningstar. Part of big-cap index funds' edge comes from lower expenses, which gives them a head start on pricier actively managed funds. On a $10,000 investment in the (VFINX Quote)Vanguard 500 fund, you'd pay some $230 over 10 years. The same investment in the (FMAGX Quote)Fidelity Magellan fund, which carries a below-average 0.88% expense ratio, would cost you some $1,200 in fees. The Magellan fund narrowly trails the S&P 500 over the past decade, according to Morningstar.

Good Reason to Be Passive Just 37% of U.S. stock funds beat the index over the past decade

Source: Morningstar. Returns through Dec. 31.

4. Don't Give Up on Growth Funds

You know the story: Growth funds rode the mercurial tech sector to stunning highs as the Nasdaq bubble inflated -- and to breathtaking losses since it popped.

It's natural to feel an urge to steer clear of growth funds. After all, the average large-cap growth fund, a staple in many portfolios, is averaging a 6.1% annual loss over the past three years. Tech-light, bargain-hunting value funds trail bonds over that stretch too, but at least they're in the black.

While it might seem sensible to choose value over growth today, a long-term investor is smarter to own both within the diversified portfolio we mapped out earlier. That's because the two styles tend to change leadership in unpredictable cycles but add up to similar gains over the long term. Owning both makes each style's valleys less painful, as we discussed in an earlier column.

5. Use Bond Funds Wisely

Bond funds have topped stocks for two straight years, going from wallflower to star.

If you're more than a decade from retirement, you might be tempted to plow into bonds, thanks to their rosy recent returns. Instead, you should still be focusing on stocks for their higher long-term gains. That said, there's still good reason to put a modest amount of money in a solid core bond fund to reduce risk without sapping returns over time. A portfolio holding just the Vanguard 500 Index fund would've fallen 12% last year, but if 10% of that money had been in a bond index fund, it would've lost only 10%. Those two portfolios would've posted similar gains over the past 10 years.

Why You Might Bother With Bonds Adding bonds can lighten your portfolio's risk, without sapping returns

Source: Morningstar. Returns through Dec. 31.

This isn't to say bonds shouldn't play a far bigger role in your portfolio as you near retirement. It's often said that once you're within 10 years of retiring, your bond exposure shouldn't be much lower than your age.

There you have it, five steps that should make your 401(k) a less troubling sight. Rip off the Band-Aid and get to work.