How to allocate your retirement fund/401k?
Congrats on joining the work force. Your chair might not be warm, but it's already time to plan how to get out of work, your retirement. The choices can be overwhelming. Here's my life lesson learned.
I am not a licensed financial advisor. I will include citations to the concepts that support my assertions.
- Untrained: One Click Retirement
- Beginner: 4 Fund Portfolio
- Intermediate: Tuning stock allocations
- Advanced: Other diversifications
- Elite
- Parting Words: Index Funds or Bust
Untrained: One Click Retirement
Here's the cheat code: Target Retirement Funds.
You pick the year your expect to retire. The fund takes care of the rest for you. Done. Pat yourself on the back. Go take a nap.
Beginner: 4 Fund Portfolio
Spoiler alert: invest in 4 funds.
- US Stocks
- US Bonds
- International Stocks
- International Bonds
In fact, this is how the Vanguard Target Retirement funds are allocated.
3 basic investment concepts
But what if I want to try this myself? So how does target retirement funds work? Simply put, they diversify and allocate your investments based on your risk profile (how long until you retire).
Risk tolerance and time to retirement
Investment is about risk/rewards. While the US economy and stock market trends upward over time, there are many peak and valleys, highs and lows, some very steep. The more time you have, the more chances you have to recover from losses (if any), allowing you to be more aggressive and take more risk. Conversely, if you are about to clock out for good, it's prudent to protect your gains: take less risk, and invest on assets that may have less returns but are more safe.
Diversification and investment types
Now that we know that time horizon allows the amount of risk you should take, we need to figure out diversification (where) and allocation (how much). Diversification is a fancy word for "not having all your eggs in one basket". If one egg does bad, we might have other eggs that are doing well to offset it. Allocation is how much to put into each "egg".
If we were to over-simply the investment vehicles available, there are two traditional types: Stocks and Bonds. Stocks have higher returns and higher risk; bonds have lower returns and lower risk.
Allocation and efficient frontier
Now that we know we have to pick between stocks and bonds, how much do I put? If I'm risk-averse, does it mean I go "all-in" on bonds? The short answer is a resounding no. The reason behind this is the efficient frontier:
Stock vs Bonds
As demonstrated by the efficient frontier curve, we should have a combination of stocks and bonds, but how much? Traditionally, it's often recommended to have "Own Your Age In Bonds (OYAIB)". It's a simple rule championed by Vanguard founder Jack Bogle. If you are 25, put 25% of your portfolio in bonds. Or if you are 40, put 40% of your age in bonds. Some people find this too conservative. There are variations where they subtract 10 or 20 from your age. Others observed that the human life span is increasing, and hence we should use 15/50 Stock rule instead. The key take away is, have some bonds now, and have more bonds as you age.
Player 3 and 4 have joined the game: International stocks/bonds
As we already learned, diversification is beneficial. Experts explain whether foreign stock investments are a smart financial move. But again, how much? Popular answers range from 50% to zero.
My personal allocation
Again, I am not a financial advisor. This is not meant as financial advice. It is a frame of reference on what I do personally. I consider myself very risk-tolerant.
- 70% in US Stock
- 20% in International Stock
- 5% in US Bonds
- 5% in International Bonds
Intermediate: Tuning stock allocations
Now that you have your portfolio allocation locked down. You might be ready tinker some more. US stocks is a very board term. You might ask, what types of US stocks are there?
In this corner: Market Capitalization
Market capitalization is total worth of a public company, taking their number of outstanding shares and mulitplying by their current stock price. Companies are classified into Large, Mid, and Small caps:
- Large-caps: companies with market cap over $10 billion (a.k.a. blue chips)
- Mid-caps: companies with market cap between $2 and $10 billion
- Small-caps: companies with market cap between $2 billion
The risk profile of the company is also implied by these market valuations. Large caps are viewed as mature companies and have the war-chest to weather a recession. Whereas small-caps are viewed as young companies companies with unrealized growth potential. In summary, large caps are view as safer but less returns, small caps are viewed as more risk but higher returns, and mid-caps are a bit in between. Of course, these are generalizations that are not always true.
In the other corner: Growth vs Value
Stocks can also be evaluated based on their price-to-book or price-to-earnings ratios. Based on how a company is doing compared to the average, we can derive an investement strategy in either Growth vs Value.
- Growth: choosing winners; invest in companies that have demonstrated better than average growth, because they are expected to continue to do well
- Value: bargain hunters; invest in companies that have strong fundamentals but are currently undervalued, because there is profit to be made when the market comes to its senses and the price normalizes
- Blend: a little bit of both; just like Goldilocks taught us
The million dollar question: How to allocate?
The answer always is: it depends on your risk-tolerance/appetite. moneyunder30.com suggests a sensical breakdown:
- 30% large-cap
- 20% mid-cap
- 20% small-cap
- 20% international
- 10% bond
My Personal Allocation
In case you forgot, I am not a financial advisor. This is not meant as financial advice. It is a frame of reference on what I do personally. I consider myself very risk-tolerant.
First, you probably heard, past performance is not indicative of future results. Second, data can indicate different conclusions depending on the data set that is used. For example, Large Caps can out performance Small Caps in a certain time frame while the opposite is true in a different period. With that said, studies over a 90 year period and 80 year period, and 26 year period all demonstrated that Value outperforms Growth and Small Caps outperform Large Caps. Hence my allocations based on macro-trends are:
- 35% Small Cap Value
- 25% Mid Cap Blend
- 10% *Other
- 20% International
- 5% US Bonds
- 5% International Bonds
Advanced: Other diversifications
Now we are being really nit-picky. How else can we make more choices?
Additional Assets Class
In 5 Fund Portfolio, they suggested to add REITs. As for me, I personally add Information Technology instead.
Dividing up the world: Developed vs Emerging Markets
Previously, we've only talked about US vs International stocks. We could further divide them by Market Classification. Here are some examples:
- Developed Markets: Western Europe, Japan, Hong Kong, Australia, Singapore
- Emerging Markets: Brazil, Russia, India, China, Korea, Turkey, UAE
My Actual Personal Allocation
One more time with feelings: I am not a financial advisor.
- 27% Small Cap Value
- 23% Mid Cap Blend
- 20% Information Technology
- 10% International Developed Markets
- 10% International Emerging Markets
- 5% US Bonds (Intermediate Term)
- 5% International Bonds
Elite
I have still much to learn...
Parting words: Index Funds or Bust
Your 401k provider may provide both Index and Mutual/Managed Funds.
- Index Funds track a specific Index, such as S&P 500 (Large Cap) or Russell 3000 (Small Cap). Since it's tracking an index, there's no one there to pick stocks, and hence the management fee is very low.
- Mutual/Managed Funds employ a team of professionals to research and pick stocks for their fund. Hence the management fee is much higher in comparison and ranges significantly, so pay attention to the Annual Expense Ratio!. They typically have an objective and asset class. So They can still have a Small Cap fund, but the selections are managed by the team.
It's hard enough to out perform the market. Hence I strictly pick Index Funds when available. And remember to re-balance your portfolio as you age.