401(k) Diversification Is Now Easier
Today, many 401(k) retirement plans offer two distinctly different investment approaches. The first is the traditional method, by which you build a portfolio from a menu of relatively narrow mutual funds--specializing, say, in large-cap growth stocks, foreign stocks or government bonds. With the second, newer approach, you direct your 401(k) money into just one very broad fund whose managers handle all of the investment choices.
Which works better? According to a recent study conducted by Burgess Associates for John Hancock Retirement Plan Service, the all-in-one fund--often known as a lifecycle fund--is worth considering. From 2000 through 2004, Hancock retirement fund participants in lifecycle funds came out ahead of those with do-it-yourself portfolios by 3 to 4 percentage points. On average, the survey found, participants who didn't use the lifecycle funds would have had 17% more in their nest eggs at the end of the period if they'd adopted the single-fund approach.
Past performance is no guarantee of your results, but this new approach to 401(k) investing appears promising not only because it is easier but it also eliminates a major threat to your investment success: you.
A chief virtue of lifecycle funds is that they shift the burden of creating a well-diversified portfolio from you to the funds' professional managers. Professionals--not you--make asset allocation decisions based on your time horizon.
If you're 30 years from retirement, for example, you could invest in a fund designed for someone your age. At first, the fund's manager may invest a large proportion of assets in stocks, with just enough bonds and cash to keep volatility at a manageable level. But as you and the fund's other shareholders age and near retirement, the manager will adjust the investment mix, increasing the fixed-income allocations to lower volatility.
Leaving asset allocation decisions to the manager of such a fund can save you from your own worst investing instincts--the tendency to load up on stocks at the height of a market surge, say, or to move everything into bonds when equities are slumping. These portfolio managers can also make tough rebalancing decisions for you, moving a portfolio back to its target allocations when, again, that means selling hot assets or buying cold ones.
In another study, of participants in Vanguard retirement plans, the mutual fund giant found that while about 70% of plan assets were invested in stocks--a reasonable allocation, given retirement savers' long-term goals--some plan participants had less than optimum investment mixes. Some 13% had all of their money in bonds and other fixed-income securities, while 21% had all-stock portfolios.
Keep in mind, though, that lifecycle funds are intended to serve as all-in-one portfolios. The Vanguard study found that fewer than one in three investors had a lifecycle fund as the sole holding in a 401(k), which is the way these funds are meant to be used. Mixing the broadly diversified lifecycle fund with traditional funds that are more narrowly focused could lead to too big a bet in a particular area of the market, thus defeating one of the main reasons for holding lifecycle funds in the first place.