Don't micromanage your 401(k)
You can keep shifting your investments around according to market conditions, but a better strategy is to diversify, buy and hold.
I moved the money in my 401(k) from stock investments to a safer investment option a few months ago. But now I’m wondering whether, given the current state of the economy, I should keep the money in the safer option or put it in stocks. Your thoughts? —Clint Candler, Lumberton, New Jersey
I think the question you really ought to be asking is whether you’re taking the right approach to handling your 401(k). It seems to me you have two basic choices.
One is to move your money among different investment options in response to economic or market conditions. The other is to adopt a long-term strategy in which you invest your 401(k) stash in a mix of stocks and bonds that’s appropriate for your age and risk tolerance and, aside from occasional adjustments mostly for maintenance, stick with it whatever the markets may be doing.
Timing the market
I can understand why the first choice may seem more sensible and appealing. After all, who wouldn’t want to shift their investments around to protect themselves against market downturns or to exploit new opportunities for gains?
The problem, though, is pulling off this strategy. Why? Well, the stock market bounces around a lot. Just look at how it’s yo-yoed up and down over the past year. It’s easy enough looking at a chart of the market’s past fluctuations to see when it would have been good to get out and back in. But in real time that’s extremely difficult, if not impossible.
I mean, when the market has been on a roll as it was back in October of 2007, how do you tell whether you should stay in for the expectation of even more gains, or bail out because a setback is coming?
And when the market dips to a low as it did in March, how do you know whether stock prices are going to keep falling or do an about face and start climbing?
You could go by your gut or take your cues from the sentiments expressed by the chattering class on TV finance shows. But that doesn’t seem like much of a strategy.
You could also base your moves on any number of stats and indicators - the shape of the yield curve, stocks’ earnings yields relative to bond rates, growth in the money supply (all of which and more are explained in a recent Money feature).
But while such benchmarks can be worth following to give you a sense of what may lie ahead for the economy and markets, I don’t think their predictive power is accurate enough to justify using them as tools for moving in and out of the market.
Set it and forget it
Which brings us to the second way to manage your 401(k): set a stocks-bonds mix and largely stick to it. On the surface, this may seem like you’re abdicating responsibility for your investments and leaving yourself completely vulnerable to the vagaries of the market.
But rather than depending on your ability to time moves in and out of the market, you are counting on your portfolio’s underlying asset mix both to generate gains and to provide some protection against (though not immunity from) downturns.
You know that stocks are going to get slammed sometimes. So the more you want to soften the blow during those periods, the more you put into bonds. You also know, however, that bonds aren’t likely to provide as high returns as stocks over long periods of time. So you don’t want to go so heavily into bonds that you stunt the eventual size of your nest egg.
I want to stress that I’m not advocating a mindless buy-and-hold strategy here. For this approach to work, you’ve got to take care in setting your initial stocks-bonds allocation. You want to make sure the allocation you settle on truly reflects your appetite for risk both in good and bad markets. That’s a balancing act. You don’t want to be so aggressive that you live in fear of a downturn, but you also don’t want to be such a wimp that you don’t participate in bull market runs.
And you’ve got to do that occasional maintenance I mentioned earlier. The cornerstone of that upkeep is annual rebalancing. So, for example, if stocks have had a big run one year, you might sell off shares of stock funds and put the proceeds into bonds (or plow new contributions into bonds). You would do the reverse in years in which bonds outperform stocks.
Doing this will assure that your 401(k) doesn’t stray too far from its target mix. it will also force you to buy asset classes that have lagged and are out of favor, which is a good counterbalance to investors’ tendency to chase hot sectors.
Aside from rebalancing, you’ll also want to be sure you gradually move more of your account into bonds as you get closer to retirement. And you’ll want to monitor the performance of your individual 401(k) investments. If a fund you bought seems to consistently lag its peers or the manager appears to be straying from his or her stated investment style, you may need to replace that fund. That can be a tough judgment call, which in my opinion is another reason to invest primarily in index funds, if you have the choice.
If this create-a-mix-and-stick-to-it strategy appeals to you, learn more about how to build a portfolio and check out examples of different asset mixes for various career stages.
If, on the other hand, you want to continue shifting your money among different investments based on your reading of economic and market conditions, that’s fine. But I can’t offer you advice on how to follow a strategy I think is flawed, other than to tell you to take care in evaluating the claims (and fees) of the many people who do advocate such a strategy and will be more than willing to help you pull it off.