Smart401k Blog

In my last common 401(k) pitfalls article I discussed a few advanced distribution strategies.  For this article I thought I would take a step back and discuss a couple things to avoid regarding the diversification of your account.

Diversification is a word that is often mentioned as an important part of investing;  but, what exactly is diversification?  Diversification is investing your account across different asset classes or market segments (large companies, small companies, international companies, etc.) in an effort to reduce the volatility in your account.  However, proper diversification does not mean simply picking multiple funds that invest in different types of companies or locales.

Risk tolerance comes into play when diversifying your account in terms of your overall asset class mix.  For example, a conservative investor  (someone that prefers to have less fluctuation or volatility in their account) is likely to have a larger portion of their account is less risky investments, such as bonds and cash equivalents, with a smaller portion going into more risky assets, such as small cap and international stock funds.  Contrast this with an aggressive investor that  could be entirely invested in stock funds with a larger holding in riskier investments.

There has been quite a bit of media attention lately talking about how diversification is dead and that the last ten years were a “lost decade”.  This is simply not true.  The data they are using is if you were invested in only the S&P 500 Index (an index of large-cap stocks).  Most investors, like yourselves, are not invested in just large-cap funds.   In fact, a recent article in the NY Times illustrated if you were diversified you, likely, didn’t have a lost decade.

Given the clarification on the “lost decade” and the importance diversification can have on retirement planning, there are a number of common diversification pitfalls to avoid. These pitfalls include investing in only one fund that is not  pre-diversified, such as a target date fund, investing in every fund in the plan in equal percentages, picking an asset allocation based on a general rule of thumb and investing a large percentage of your account in company stock.  I’ll address the first three here and will follow up with an article on company stock.

One Fund This usually happens when an investor picks the fund that’s performing the best in the plan, or when an investor is entirely in cash.  Investing in the hottest fund can be extremely harmful to your account, as a fund that has gone up 60% in a year can just as easily decline 60% in a year.   And while it’s true that you are not subject to the volatility of the market when you’re invested entirely in cash, it’s also true that will likely lose money over the long-run  due to inflation.

Investing in Every Fund Investing in every fund will give you some diversification but it likely will not give you an appropriate asset allocation.  Investing in every fund could put you overweight in certain asset classes and result in more or less risk in your portfolio than you intend.

General Rule of Thumb There are a number of rules of thumb communicated to investors, including the Rule of 110.  This rule suggests that the percentage of your account that should be invested in equities can be determined by subtracting an investor’s age from 110.  While the Rule of 110 can provide a valuable starting point, it should not be construed as an end point.  Constructing a portfolio should be done not merely by picking an asset allocation based on your age, or a general rule of thumb, but by doing research or consulting a trained, unbiased adviser that can help you put together a portfolio based on your risk tolerance, investment goals and time horizon.

If you need help putting together a diversified portfolio, please contact us or another trained investment adviser.  In the meantime, please feel free to contact me directly at 913.744.3376 or by email at bwendel@smart401k.com with any questions that you may have regarding diversification.  Also, please keep an eye out for the next installment of Common 401(k) Pitfalls.

Buck

This entry was posted on Wednesday, March 10th, 2010 at 4:13 pm and is filed under Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.