401(k) Investing, Part 2

The ins and outs of risk, asset allocation and dollar-cost-averaging.
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Too many choices, too little time. The boss always has a rush project. You want time with your spouse or significant other. And if you miss one more soccer game with your athlete kid, you're dead! So you say, "The heck with it, I'm just going to dump all my 401(k) money in the money-market fund -- at least it will be safe," and you end up making the single biggest mistake that 401(k) participants make. By default, you are too conservative, and you end up missing out on thousands of dollars at the end of the line.

You simply have to find time for yourself and your 401(k). Think of it as your most significant retirement asset. Last week, I discussed the first four steps. Now let's look at the final steps.

Step 5.

Identify the risk associated with each investment option. The risk issue is one of the biggest stumbling blocks to making an investment decision. The sponsors of your 401(k) should have good information on the risk of each mutual fund. You also can check

Morningstar's

risk ratings. If you find it difficult to understand beta, alpha, standard deviation and sharp ratios, think in terms of offense and defense.

Brenda Buttner's

column is a good place to start learning about risk. Also, my June column on risk and my July column on defensive funds will give you some further background.

Step 6.

Figure out how you want to allocate your money to the various investment choices. Your 401(k) plan booklet should have some allocation models. The choices generally are classified as low-, medium- and high-risk. You should not base your decision just on your age. Your decision should include the number of years you have before you retire.

From a pure time standpoint, if you have five or more years, you could stand at least medium risk. Medium risk means that a full market cycle -- from a top in the market through a drop and back to the same top -- would take about five years in most circumstances. This would give you sufficient recovery time. By that definition, you could have all your money in a large-company growth fund and be fine.

If the trip through the market cycle is too volatile for you, you could "tame" it by adding more fixed-income funds to your allocation. For instance, if you really are scared of the market, you might put 60% in stock funds and 40% in short- to intermediate-term bond funds. This middle-of-the-road approach would give you more return than an all-fixed-income portfolio and less return than an all-stock-fund portfolio.

This year's third quarter provides a graphic example of what diversification can do. The average stock equity fund dropped more than 15%, but the average government bond fund went up 4.6%. If you started the quarter with 40% of your portfolio in bond funds, you would have cut your overall loss by a little more than half, to 7.2%.

Be sure to read the definition and purpose of each of the funds. Rather than trying to figure out the allocation, some 401(k) plans have lifestyle funds and asset-allocation funds. These funds do some form of allocation for you. If you are new at investing, you may want to start with these kinds of funds. As you gain more knowledge and experience, you can then do your own allocating.

Step 7.

By having the same amount of money deducted from your paycheck each pay period and investing in the same funds, you automatically will be dollar-cost-averaging. That means, during bad times, you money will be buying more shares. If you put, say, $100 into a $10 stock, you have 10 shares. If the stock price goes down to $5 a share, the same $100 buys 20 shares. When the stock goes back up, you made more money because you have more shares. Conversely, if the stock goes to $20, the same $100 only buys five shares.

The effect of dollar-cost-averaging is that over time you end up with more money. This concept is primarily true when we have up

and

down markets. During a prolonged up market, you may think dollar-cost-averaging doesn't work. So, you need a certain measure of patience at times. As soon as the market goes down, it starts working again.

Dollar-cost-averaging tends to reduce risk over time, so try not to move your money around based only on market behavior. Don't get dollar-cost-averaging mixed up with timing the market. Timing means you pull all the money out of the market when it goes down and put it all back in when it goes up. Sounds good, but it doesn't work, primarily because you can not predict the market and you'll miss the upticks. For instance, all equity funds combined returned an average of 15% annually from 1982 to 1997. The

S&P 500

rose about 19% a year over that period, so the funds did worse. But how did the average mutual-fund investor make out? Even worse, only about 10%. How come? People tend to get excited in hot markets and buy at the top, but when the market deteriorates they sell at the bottom. Enough said.

Step 8.

Review your 401(k) results every quarter. Measure your results against appropriate benchmarks. The S&P 500 benchmark should only be used for large-company stock funds. The

Russell 2000

should be used for funds that invest in small companies. Most importantly, measure your investments against your objectives. If you're conservative because you're scared of the market, you could still be reaching your goals but not match any particular benchmark. On the other hand, if you were aggressive and took a loss in the third quarter, it doesn't mean you have to change strategies. The point is to actively manage your 401(k) portfolio. Pay attention to what is going on, but once your allocation is set do not change it because of your emotions. Have some good reasons for making any changes.

Step 9.

At some point, you will either retire or leave the company. At that point, you must decide what to do with your 401(k) money. If you are going with another company that has a 401(k) plan, I generally suggest using a "conduit IRA." This special IRA will allow you to invest your money into your new 401(k). You may not want to do this, but it gives you the option of doing it. For people retiring, the best option for most is to roll the money into an IRA using an independent custodian. This will enable you to "self direct" your own investments.

There are entire books written on 401(k)s. In these two columns I have just covered some of the highlights, hoping it helps you to stay on a successful track.

I want to thank so many of you that sent me email this week. There are a couple I would like to share with you. A special thanks to

Mark Burns

for his email stating, "Please do not think the whole retirement world is 401(k) egocentric. Please remind your readers working for not-for-profit organizations that a 403(b) is just as good as a 401(k)." This is absolutely right. While there are a few differences, I would encourage everyone in not-for-profit companies to take advantage of a 403(b).

Another thank you to

David Geidel

, whose 401(k) account balance was lower at the end of the third quarter than the second. David speaks for many in that situation. One of his statements really hits home: "The upshot of all this is that, for now, I feel my best strategy is to buy and hold and let dollar-cost-averaging do what it can for me." David, your stealing my lines. I couldn't have said it better!

Thanks again, and keep those emails coming.

Vern Hayden is a certified financial planner with the American Planning Group in Westport, Conn. His column is not a recommendation to buy or sell stocks or to solicit transactions or clients. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks or funds. Hayden welcomes your feedback.