The last several years have done a number to many people’s nestegg. Many people who relied on their 401k for their approaching retirement were no longer able to retire because their 401k lost so much value in the market due to the credit crisis. If you want to protect your 401k from massive losses, follow these three tips. These tips are designed to protect your assets moreso than growing it. Therefore these tips are meant for those who are going to retire soon(ish). But if you follow these tips, you should also see some good growth in your 401k.
Reassess Your 401k At Least Once A Month
A lot of people lose money in their 401k because they do not actively manage it. Just because your 401k is a mutual fund and managed by someone else does not mean you don’t have to look at where your investments are going it. Market conditions change and you need to adjust your 401k accordingly. This will mean you will have to take a more active approach in your 401k investing. When reassessing your 401k, do not look for news and rumors of certain companies or sectors. Rather, look at the marcoeconomic climate as a whole. For instance, if you saw that your foreign fund invests largely in the EU. Because of the ongoing EU troubles (with austerity and whatnot), you might want to take a look at that fund and see if you want to continue investing in it.
If you do not know enough about the stock market, you should pick up a book or two to read the basics. It doesn’t take a genius to invest in the stock market and get a positive return. But it does take a little extra to beat the market average. The market average is a perfect segway into my next point.
Do Not Rely On Long Term Averages
A lot of people depend on long-term market averages for stock investing. That can be a fatal mistake. The reason for that is because the average depends on a sample size that spans multiple decades and centuries with no account for investment horizons. You will not be in the market for that long. Investment experts like to tout that the long term average for market returns is 8 to 10 percent. Tell that to people who were about to retire a few years ago. Some of them lost nearly half of their retirement nest egg in a matter of a year. The market average is a mathematical axiom. However, it does not apply to you—the market average is not bounded by real life factors such as age and years to retirement. Your investment decisions should be based not on the long term market average. Rather, your decision should be based on your retirement horizon—which brings us to our next point.
Invest According To Your Time Horizon
Your time horizon essentially means how many years you have left until retirement. The closer you approach retirement, the more conservative you should be with your investments. If you are a few of years away from retirement, you should have a lot of your money in fixed income; at least half in my opinion. Fixed income can come in the form of government and corporate bonds. They are extremely safe when compared to the stock market. If you are only a few away from retirement, your mindset should be switched from a growth mentality to a protect mentality. On the other hand, if you are young and have at least 20 years until retirement, you should have most of your investments in the stock market. Whether you invest in large cap or small cap or even foreign investments will depend on market conditions and your risk appetite. The point is to take more risks while you are young and focus on growth of your nest egg because you have more time to recover if your assets lose value. This is where market averages come into play—over the course of 20 or so years, your investment will return a healthy 8 to 10%.
Diversify Your Portfolio
I’m sure you’ve heard it before. Diversification in your portfolio is important as it mitigates risk inherent in the market.
You may think that your 401k is already diversified without you doing anything because it is investing in mutual funds. That is not real diversification. Yes, each fund you invest in holds a plethora of stocks to hedge risk. But to truly hedge risk in your 401k portfolio, you have to invest in multiple funds in your 401k. Here is what my 401k looks like right now: I have 20% in fixed income, 30% in large cap stocks, 40% in medium cap, and 10% in international. Keep in mind that my investments are not weighted evenly; I invest the most in medium cap stocks, then followed by large cap, then fixed income, then foreign investments. How much I invest in each fund may change in a few months as I adjust to market conditions. This is not a recommendation of what to do—my portfolio reflects my time horizon and my risk appetite.
A word on diversification—don’t overdiversify. The savviest investor investor to ever walked the Earth, Warren Buffett, even warned against overdiversification. At one point, 5 of Buffett’s stocks accounted for 73% of his portfolio. Here is a quote from Warren Buffett on the issue of diversification:
‘Many pundits would therefore say the [this] strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.’