401K Plans: Beyond the Basics Part 1

It has been said that every day when the market closes, whether the market had a good day or bad day, everyone cheers at the closing bell. Well, all those people who are cheering are stock brokers or earn their income from the Wall Street financial industry in one way or another. These people are cheering because whether or not investors had a good day, stock brokers made money buying and selling stocks for their clients. But most people will never have to worry about the rise and fall of the stock market because it is just too volatile for the faint of heart. Well, that is to say, everyone who doesn’t yet have some form of 401K retirement plan through their private sector company won’t have to worry; which also includes 403B for Public Schools and tax-exempt organizations and 457 for state and local governments and other tax-exempt organizations; so from here forward when referring to 401K plans, it will include anything similar offered by all non-private sector employers. What are all these retirement plans and what do they mean? Basically, the general and permanent federal law of the United States is called United States Code (U.S.C.), which contains 50 Titles. For example, U.S.C. Title 10 covers the Armed Forces and Title 26 covers Internal Revenue Code. So, deep in the bowels of Title 26, specifically Subtitle A, Chapter 1, Subchapter D, Part I, Subpart A, § 401 (Qualified pension, profit-sharing, and stock bonus plans) is where all the lawyer speak is that authorizes and establishes what we simply know as 401(k) retirement plans if you work for a private sector employer. Yes, a lot more information than you cared to know, but at least you understand the reference.

 If you’re a student of investing and have been doing your own research and self-education by reading books from Benjamin Graham and Warren Buffet, then you probably already have a good understanding of the risks of investing. To keep it simple, we are just going to focus on how to navigate through the jungle of our company’s 401K offerings. First thing you will have to deal with is your own emotions; specifically, how adverse to risk are you as an investor. If your selections are going to keep you up at night and make you worry until you are sick then the choices will be fairly obvious. But if you are more risk tolerant and understand that you have 10 or 20 years before retirement and can keep from checking your 401k account every day then you may be able to be a bit more aggressive and weigh heavy in the funds that tend to hold stocks. Keep in mind though that we need to keep a balance of high risk stock funds and low risk bond funds so that we can weather financial storms. So let’s look at just a few different fund choices to get a feel for what we are getting ourselves into.

From my experience, 401K plans offered by some employers will provide you with a market basic of well-known mutual funds with as many as 15 or more different choices. Some employers contract out the management of their 401K plans to companies like T.RowePrice or Putnam Investments, so I will refer to the “company” from here on out when referring to whomever runs your companies 401K plan. Generally, these choices will be categorized by what type of financial instruments they tend to hold in the fund. Some mutual funds will have categories like: Growth Investments, Blend Investments, Value Investments, Income Investments, Capital Preservation Investments, and Asset Allocation (ready-mixed) investments. My current 401K company offers 28 different choices spread across these 6 different categories. I know at work I have a lot of fellow employees that are pretty much overwhelmed with the amount of choices and a lot of them feel pretty intimidated by the complexity of want in theory is supposed to be a simple retirement plan.

A mutual fund by definition is a conglomeration of many different stocks and/or bonds all held in a fund that is typically managed by a fund manager who pools all the money from many investors to buy and sell investment securities to be held under the fund name. So, a mutual fund is already a diverse holding of many companies across many sectors of the market. In my mind, this makes my personal decision about how many different funds I’m going to hold in my 401K plan a lot simpler. Fund managers make their money by making sure that the fund investment objectives are succeeding and making money for their investors for the long-term. A fund manager will buy and sell shares for their fund on a schedule to follow market trends and keep their funds current. Some managers are better than others, so if you truly want to be a student of the market you should start by researching the fund managers themselves of the different funds you are interested in selecting for your 401K portfolio. Otherwise, like myself, I look at the historical data and contrast and compare the results over time (Fig. 2). For my own personal investing philosophy in my 401k fund I select between 3 and 5 different funds, out of the 28 choices, and I keep a balance of high risk stock funds and low risk bond funds. Currently I’m weighted more heavily in the bond funds because I don’t trust the markets near to long term prospects.

Personally, I don't like the ready-mixed asset allocation funds, because they are generic funds that are supposed to be aimed at a specific targeted retirement timeline. There's no real incentive for these funds to perform well. I do prefer something with name brand recognition because they tend to be availabe to investors outside just the company that manages my 401K plan, so there are many more investors in the fund and more pressure on the fund manager to perform well.

Let’s take a moment to look inside a mutual fund to get a better understanding of what it is that we are going to put into our 401K portfolio. We will use Vanguard Small-Cap Index Fund, ticker (NAESX). According to the funds objective it seeks to track the investment performance of the MCSI U.S. Small Cap 1750 Index. MSCI is a company that makes investment support tools, and has a number of different indexes which reflects different sectors of the market. The Small Cap 1750 index is one of them. As you can see from this look under the hood that it is almost purely a stock fund, with 1.69% of the fund from foreign stocks. So If I didn't have any foreign specific funds, I still get a little taste of the foreign market through this fund. After looking at the sectors by percentages and some of the holdings of this fund, it probably would be considered a high risk stock fund. If I were to choose to have this fund in my portfolio I would probably own a very small percentage if I were a risk adverse investor.

Asset Allocation

Cash 0.38%

Stocks 97.94%

Bonds 0.0%

Other 0.0

Foreign Bonds 0.0

Foreign Stocks 1.69%

Convertible 0.0%

Preferred 0.0%

Below is a snapshot of some of the offerings from my mutual fund company. As an example: if I were a risk tolerant investor I would pick the three funds highlighted and then balance them either 25/25/50 from top to bottom to be balanced, 25/40/35 to be more risky, or 20/20/60 to be more conservative. If I thought that foreign investments should be a factor in my portfolio then I would also include the Templeton Foreign Fund; some people would recommend having at least a little foreign securities in their portfolio to take advantage of other markets around the world, the decision is totally up to you.

For full disclosure, I’m not a financial advisor, stock broker, nor do I hold professional licensure for buying or selling financial instruments on the behalf of others. Do not make any financial decisions based upon any suggestions or recommendations of this author until you have done your own due diligence.

If you found this article helpful or have any questions please let me know and I will be glad to offer some more of my thoughts and ideas.