Blackstocks.com: In the Know

Making The Most of Your 401(k)

Choosing Your Funds

Out of all those funds your plan may offer, how can you know which ones to choose in order to get the best return on your 401(k) investment?

Well, if you are clairvoyant, the answer is simple. All you have to do is put all your money in the fund that you know is going to soar in value.

However, if you are like the rest of us, you have no idea which fund is going to rise more than the others. In this case, the best strategy is to use a carefully calculated combination of funds.

What is asset allocation, anyway?

The method used to calculate such a combination is called asset allocation. A good asset allocation is the Holy Grail of investing, but according to one recent survey most 401(k) participants don't even have an asset allocation strategy.

Asset allocation means dividing up (allocating) your investments (assets) in such a way that they work together to give you the smoothest ride toward your investment goal. The idea is to choose funds that are expected to do well in the long run, but that do not move up and down in synch with each other.

Imagine, for example, that you are driving up a mountain. One road leads you to your destination on a gradual slope. Another is a roller-coaster road that takes you up steep hills - some even higher than your destination - and down into deep valleys, eventually bringing you to your destination with one heck of a stomachache. Which one would you choose?

By spreading your 401(k) over several funds, you will not achieve the highest returns possible in your 401(k) each quarter. That would require putting your entire investment in the single fund that was going to do the best - and unless you are the clairvoyant that we were talking about earlier, you can't possibly know which fund that will be.

Asset allocation strategies

Asset allocation is based on modern portfolio theory, which says that the critical first step to developing a suitable investment account is deciding which types of assets you want to buy, not which individual stocks and bonds you like. Investing in many different asset classes makes more sense than worrying about whether a particular security is ' safe enough' to put your money in.

Here's some help with developing the best asset allocation strategy for you. Of course, these are general guidelines that don't take into account the details of your particular situation, and they should be viewed as such. They are educated guesses that are based on historical data. When it comes to trying to predict the future, economists agree with the immortal patriot Patrick Henry, who said:

' I know of no way of judging of the future but by the past.'

Below are pie charts that illustrate suggested asset allocations for different age groups based on the historical returns of and correlation between asset classes. (Correlation means how similarly the classes behave - for a more detailed explanation please see Wall Street 101.)

All allocations assume a retirement age of 65:

In your 60s?

In your 50s?

In your 40s?

Classify the funds in your plan

At this point you're probably thinking, that's great, but I still don't know which funds in my plan to invest in.' Hang on to your portfolios, investors, because that's what we're going to look at now.

How Asset Mixes Influence Your Total Return

How Asset Mixes Influence Your Total Return

Under Modern Portfolio Theory, the critical first step to developing a suitable investment account is deciding which asset types you want to buy, and not which individual stocks and bonds.

Investing into many different asset classes makes more sense than worrying about whether a particular security is in itself "safe enough." Even the riskiest securities, like junk bonds and derivatives, can add value to a low-risk portfolio if they are used in the proper proportion. The impact of a security on the total portfolio is the paramount concern.

 

So if you want to get a higher return for the same risk, or reduce your level of risk for the same expected return -- in other words, make your portfolio more efficient -- you would be smart to consider investing in the full spectrum of "safe" and "risky" asset classes, from money market funds to small cap stocks.

Getting Into Investments That Reduce Risk

Getting Into Investments That Reduce Risk

Modern Portfolio Theory considers the total performance of an investor's account. When you plan your investments, consider the shape of the whole account. Don't think about how risky an individual stock or bond is, but about how risky it makes your whole bundle of investments.

The risk, or fluctuation in return, of your total investment account can be derived mathematically. It depends on two factors -- the risk of each individual investment and the correlation between the investments.

It is that second factor that many investors forget about when determining their risk. The risk of your total portfolio is not simply the average risk of all the individual securities. To gauge your risk picture accurately, you must understand that assets don't all go up or down at the same time.

We've already mentioned correlation. When two assets are positively correlated, they move in the same pattern. More importantly, when they are negatively correlated, they move in opposite patterns, as in the graph above. This "zig-zag" effect allows you to balance your investments, so that one investment, in theory, will always be rising when another is falling (in practice, securities don't move so neatly or predictably).

So, remember this crucial point when you are shaping your investment portfolio: the less your assets move together, the better off you will be.

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Maximizing your nest egg

Maximizing your nest egg - diversify

Maximizing the Performance of Your Total Portfolio

Diversification does more than just reduce risk. Over time, an intelligently diversified portfolio will almost always outperform a single holding. Indeed, even a not-so-intelligently diversified portfolio will probably do the same.

In fact, a case study has shown that even five randomly selected stocks would add value to an account. If they are chosen at random, they will probably be in different industries, grow at different rates, and respond differently to market forces. Long-term, an account containing these five stocks would have a higher average value than one containing only one of the stocks.

While nobody would advocate such a coin-toss approach to investing, there is a good case to be made for the passive strategy of investing. We looked at this in the Investment Vehicles chapter, under index funds. A passive strategy means that you buy a group of stocks that is diversified and hold on to them. Your portfolio doesn't need to be "managed" -- that is, with stocks and shares constantly being bought and sold. One passive investment method is to choose a selection of stocks that are representative of the overall economy, so that, for example, the percentage of General Motors stock you buy (your "weighting") would reflect GM's size compared with other companies in the U.S. economy's corporate sector.

Diversification, when is enough, enough?

Diversification, when is enough, enough?

The fact that you're invested in a 401(k) plan gives you some level of diversification, since mutual funds are by nature diversified, and a 401(k) plan gives you several fund options.

We've seen that adding assets to your account reduces the amount to which your fortune is tied to the performance of any one stock or bond. We've also seen that when assets have a low correlation to each other, they can act together to enhance the value of your account.

But is there an adequate level of diversification? According to some financial experts, an appropriately diversified portfolio -- one which gives you adequate risk reduction while still holding out a substantial reward -- would contain about 30 securities.

How to Spread the Wealth

How to Spread the Wealth

Most of the techniques for diversifying an investment portfolio come easily to 401(k) investors; the composition of most plans naturally promotes diversification.

Here are some steps to follow when building a diversified investment account.

• Invest in more than one asset type. You do not have to limit your investments to just one asset class. In fact, most investors hold a diversified portfolio containing stocks, bonds and money market investments. A portfolio such as this has two major advantages. First, you can tailor your investment choices to the level of risk appropriate for your goals, time horizon and risk tolerance. Second, by including all three of these asset types in your portfolio, you take advantage of the fact that they are not perfectly correlated -- that is, each type performs well (or poorly) at different times, so that at any given time one will be up while another is down. This reduces the overall risk of your portfolio.

• Buy different varieties of the same security type. Within stocks, bonds and cash investments, you can find plenty of variety in terms of risk level and return. Stock investors can get exposure to both the slow and steady performance of blue chip stocks and the exciting growth possibilities of small cap stocks. Investors who buy fixed income instruments can diversify by choosing bonds with different maturity dates and interest rates, such as T-Bills and Treasury bonds. They can also invest in bonds with different credit ratings from the three major rating services, which grade bonds based on their assessment of the issuer's ability to meet payments: the lower a bond's rating, the higher the interest it pays.

Investment Tip #101 Diversify, Diversify, Diversify

Investment Tip #101 Diversify, Diversify, Diversify

Diversification means splitting your money among several investment options, so that if one option you choose does poorly your entire investment won't suffer the same fate.

Suppose you invest all your money in a single stock: Intel Corp., for example. Your entire investment will be wrapped up in that company's performance. The return on your investment will depend on internal factors such as how well the company's products do, how successful its R&D (research and development) is, and what personnel changes it makes, not to mention external factors such as how well the microprocessor industry as a whole performs. Intel is a great company, but nobody's perfect, and every downturn in Intel's fortunes will affect your entire investment.

An Ideal Basket for Your Investment Assets

An Ideal Basket for Your Assets

For every investment goal, and for every set of investment options, there is an asset allocation that could reasonably be called ideal. This is the efficient portfolio, the one that offers the correct balance between risk and potential return.

 

The idea of an efficient portfolio was first introduced by Harry Markowitz in the 1950s. This model measures not just how risky an asset is, but how much potential return you can get from a given level of risk.

 

At the lowest level of risk on the graph, is the minimum variance portfolio. As we move away from that point, to the right on the "risk" axis, risk increases. But just because risk and return are related, you shouldn't assume that increasing your risk will automatically increase your return. In fact, many portfolios have high risk without a correspondingly high return potential. We can call these inefficient portfolios.

Fortunately, for every inefficient portfolio on the graph, there is a portfolio with the same level of risk and a greater potential return directly above it. If we find the portfolios that have the best possible return for the level of risk, and draw a line through those, we get the efficient frontier line.

Any portfolio whose level of risk and reward can be located on that line is an efficient portfolio. For any given level of risk, it has the highest potential rate of return. Conversely, for any desired rate of return, the efficient portfolio will have the lowest risk level. It is efficient in the sense that it doesn't take any unnecessary risk and doesn't sacrifice any potential reward. Any other possible asset mix will be less efficient.

All the work that goes into planning investment packages for individuals focuses on finding the right point on the efficient frontier. If there is a way to find an ideal asset allocation, this is it.

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No Single Investment Has It All..You All

No Single Investment Has It All

Stocks are the most exciting investment option because they have consistently outperformed other asset classes. They are far more volatile and risky in the short term, but stocks as a class have done better than bonds or cash investments year in and year out, and have produced better overall returns over the long term.

In a 72 year period from 1926 through 1997, the S&P 500 Index reported positive annual returns 52 times. Of course, that also means you've got to be prepared for declines about 28% of the time.

You don't, however, have to bear the full brunt of those declines. Mutual funds have techniques for minimizing this kind of loss. What's more, the "zig-zag" effect that you get from investments with a degree of covariance (that move out of sync) helps to smooth out the rough spots in your account's performance.

How to Get Out of Sync

Correlation is the degree to which two investments move together. When you build your portfolio, you want to invest in asset classes with low or "negative" correlation, because these move independently and allow you to hedge (protect) against fluctuations in return. Though it may sound odd, in this case "negative" is good!

If two investments have perfect positive correlation, their performance will be identical. You could track their ups and downs point-for-point, and they would always match. Financial economists call this a correlation of +1. On the other hand, if they always move in opposite directions -- if they have perfect negative correlation, their correlation is -1. If two investments move independently, their correlation is 0.

Any variation between +1 and -1 is possible, and indeed, this is where all correlations occur. No two assets have a perfect negative or positive correlation. Finding even a partially reliable relationship between two securities is difficult.

Economists use some rules of thumb to judge how different industries and different types of securities move, but determining economic cycles is itself an inexact science. So when you think about correlation, remember that there really are no perfect examples of it in the real world.

Correlation can be measured at the level of asset class. The oldest and most often repeated example of negative correlation is the relationship between stocks and bonds. For years, it has been believed that stocks generally do well when bonds do poorly, and vice versa. This belief took a real pounding in the mid-1990s, however. Just to prove that we are living in the real world, stocks and bonds both fell dramatically in 1994 and shot up in 1995.

It is also important to look at the level of correlation among stocks in different companies. The performance of stocks in commodities (such as chemicals or metals) often lags behind the rest of the economy by a few months, so they may continue to do well when retailers have begun to slide, and then will probably remain low for a while once the economy rebounds.

Some economists see a negative correlation between restaurants and supermarkets. When people have a lot of money to burn, the theory goes, they can afford to eat out and restaurant stocks do well. When money is tight, consumers economize by buying food from the store and eating in, so supermarket stocks do well.

If these examples seem tenuous, it's because they are. When you're dealing with even one asset, it's difficult to guess future performance with any reliability. Guessing how two assets will perform in relation to each other is even harder.

Here are three hypothetical companies whose respective stocks might have different degrees of correlation:

• Big Bang Corp., The largest manufacturer of fireworks in North America.
• Appleland Unlimited, a startup company gambling that consumers will flip for the great
• taste and safety of shrink-wrapped, factory inspected candy apples.
• Great Pumpkin Ventures, a nationwide distributor of farm-fresh pumpkins.

All three companies' products can be said to have seasonal demand. For Appleland and Great Pumpkin, demand picks up through the fall and peaks around October 31. Big Bang has its best sales in the summer, with peak business coming on or about July 4.

Over the course of the year, stocks of the three companies might look like this:

Appleland and Great Pumpkin have a very high positive correlation. Big Bang has a very strong negative correlation to the other two. Its stock does well when the others do poorly, and vice versa.

Even in this simple example, there is no perfectly reliable correlation. Big Bang does most of its selling in July, but sees upticks in demand at New Year's Day, Labor Day and other national holidays. Appleland (which probably has the shakiest business plan of all three companies), finds that after Halloween consumers lose all interest in candy apples. Great Pumpkin's business also peaks around Halloween, but its sales remain brisk through Thanksgiving.

In real life, calculating a pattern of correlation requires sophisticated math techniques and is never simple. But knowing that you should try to invest in assets with low correlation already puts you ahead in the game. With a bit of research and thought, you should be able to find some.

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Finding the Right Mix

Finding the Right Ingredients for the Pie

"Style analysis" is the study of how a fund invests among different asset classes. In the financial press, you will often find references to a particular mutual fund's "position" in certain securities, meaning how much of the fund is invested in a particular security.

 

To fully understand the concept of "style analysis," it is useful to know that stocks fall into different categories.