Wednesday, April 30, 2014

An Investment Strategy for My 401(k)

This is part 8 of 14 of my series on the 14 ways I am changing my financial life in 2014.

[Author's Note: This article is not an offering of investment advice. It is merely a representation of how I choose to invest my personal 401(k) account. I will not give details on specific investment choices, focusing rather on principles I have used to guide my decisions.]

In my last post about creating your personal financial statement and using it to improve your net worth, I said the following:
"If free cash flow is how we grow our net worth, then we want as much of it as possible!"
Having extra money around and using it to pay down debt or saving/investing is not the only way to grow our net worth. Another effective way to grow net worth is to grow the assets we already have through a smart investment strategy. But I am guilty of not applying that simple principle, and I have changed in 2014. 

As I have gone through this financial overhaul this year, one glaring oversight was my lack of an investment strategy for my 401(k) funds. I have religiously deferred money from my paycheck into the plan, but I failed to put more than 2 minutes into where the money was invested. This may not seem like a big deal, but I have received formal education as well as gained several years of professional experience on how to analyze investment options and put a plan together to accomplish the best results. I an guilty of neglect with my own assets, specifically my 401(k) retirement funds.

In creating my investment strategy, I followed these steps:
  1. Determine allocation of stocks, bonds, and cash
  2. Decide how to diversify among the different asset classes
  3. Select the best mutual fund available for each asset class in my retirement plan
  4. Transfer my existing balances into the new mutual funds selected
  5. Adjust my ongoing deferrals into the new mutual funds
  6. Create a plan to re-balance my portfolio quarterly
Understanding the time horizon for the money invested helps to determine risk tolerance. I have at least 20 years until I retire. I just turned 40-years-old, and most retirement accounts are subject to an early withdrawal penalty if I take out money before I turn 59 1/2. I may work a lot longer than that, but I know I won't be touching this money for at least 20 years. 

Stocks are the most volatile, or are considered the most risky, yet research shows they also produce, on average, the highest returns over the long haul. Bonds generally have a lower return and are considered less risky. And cash is often FDIC insured, meaning it is not very volatile, or risky, yet promises very low return opportunities. 

I can expose myself to a lot of risk with my retirement funds. When lumped in with all of my assets, I have bonds and cash in other places, enough to create the right balance for my entire asset portfolio. So I decided to invest 100% of my 401(k) into the stock market.

Knowing that I am 100% into the stock market, I need to figure out the best way to allocate my 401(k) plan among the available asset classes. I decided to allocate and diversify as follows:
  • 25% - US Large Companies
  • 25% - Medium-Sized US Companies
  • 25% - Small US Companies
  • 25% - International Companies
I could buy one company's stock in each of these four asset classes with all of my 401(k) money, but that would represent putting all of my eggs in one basket. Even if I really believe in those four companies, sound investment strategy follows a disciplined plan to diversify among many different companies of various sizes spread across the globe within many different industries. Mutual funds provide a great vehicle to diversify among many different companies, even if I have just a little to invest. In total, my 401(k) plan has 27 investment choices. I read about all of them, looked at their historical performance, and reviewed their Morningstar rankings. I also determined which types of companies in which they invest. I found very good mutual funds for each of the asset classes mentioned above. In total, I am invested in 6 mutual funds in my 401(k), totaling 25% in each asset class.

With a clear investment strategy, I was excited to transfer out of my existing investment choices and into my new plan. As I did this, I was reminded how poorly I had done in selecting my mutual funds when I first enrolled. Not that the mutual funds individually were bad, but that collectively they did not represent a cohesive strategy for my 401(k) and other assets.

Since I have part of every paycheck deferred into the 401(k) plan, I updated my deferral allocation based on the 6 mutual funds I selected, ultimately representing 25% into each of the identified asset classes. This means all of my ongoing investments are aligned with my overall strategy.

Now that everything is perfectly in place, I just leave it alone, right? If only it was that easy! On the very first day after I had accomplished the transfers and changes to my ongoing investments, everything started to fall out of balance. Different asset classes go up and down at different times. This is one of the benefits of reduces overall volatility. Yet I found over time that my portfolio fell further and further out of balance. There are many schools of thought surrounding the need and timing for re-balancing a portfolio. I chose to do it quarterly. I created a simple spreadsheet that I complete at the end of each quarter, and it tells me the transfers I need to make to bring my portfolio balance back into alignment with my overall strategy. 

Regular re-balancing has an additional benefit. It forces me to buy low and sell high. If some mutual funds go up more than others, I will sell some of my shares in those funds and put that money in the under-performers, meaning I am buying low and selling high every quarter. Over time, this should help the overall returns of my portfolio. 

With 100% of my 401(k) in the stock market, I need to be ready for big spikes and dips in the value of my portfolio. The stock market is volatile, and I now own a broad piece of it. At times I may feel tempted to divert from my investment strategy, afraid that the market might go down or in an attempt to try and time certain moves in the market. But research shows emotional moves hurt overall portfolio performance. 

So how do I temper such temptations? It is really quite simple. I make sure I am putting some of my paycheck into the 401(k) every month. If the market is down, I know I am still winning because I bought low with the money I just put in. It helps me to have patience to wait for the rest of my portfolio to return to and eventually exceed where it once was.