Roadmap to Riches   
how to invest your 401(k)
The Strategy: What mix of my fund choices will best help me reach my goals?
To determine which fund or combination of funds makes the best sense for you, you need to begin with the most basic economic fundamental.
“When do I plan to need this money?”
Next, you would review the basic investment fundamentals of the different asset classes and their risk/return relationships:
Understand how different asset classes meet the needs of different goal time-frames.
Cash
2 to 4-year goal - Money market funds preserve cash. The money will always be there.
Bonds
4 to 7-year goal - Bonds can drop in value, but they will generally earn more than cash.
Stocks
7 years or longer - Stocks are most profitable, but they can lose the most in single years. You don’t have to be a genius to invest your 401(k) successfully. You just need to appreciate what makes stocks go up and down.
Seventy percent (70%) of any one stock or mutual fund’s performance is based upon what the stock market as a whole is doing. You can have the greatest mutual fund or stock in the world, but if the stock market is going down in value, there is a 70% chance that your great mutual fund will also be dropping. This means that even if you picked one of the worst mutual funds available, you would still do at least 70% as well as the average fund. In recent years, the market has averaged about 16% per year. Anyone throwing darts at stocks in the Wall Street Journal would have done as well as 80% of all mutual funds.
NOW, we can combine some economic and investment fundamentals and see how they apply to real life situations.
First, we need to ask ourselves which of these three basic levels of risk best describes our basic comfort level.
Conservative Investor
“I need to know that my investments are increasing steadily each year. I realize that this psychological requirement will mean lower returns in the long run.”
Moderate Investor
“I am willing to accept occasional losses knowing that accepting this risk is the price I need to pay for higher returns over time.”
Aggressive Investor
“I am seeking maximum long-term gains and will not be concerned about short-term losses.”
The following matrix illustrates what we can expect in returns and risk levels from the different percentage combinations of stocks and bonds. These averages are based upon the twenty and thirty-year periods ending in 1993. We have chosen these periods because they incorporate some of the better markets of recent years without including the unprecedented string of annual gains we have seen during the three years of ’95 through ’97.
The “Expected Short-Term Loss Possibility” is an illustration of what each investment mix experienced during the “crash” of 1973-1974.
The “Recovery Rate” illustrates the degree to which each mix has gained in value as of the period from January 1, 1973 to December 31, 1976. For example, a mix of 100% Stocks worth $100 at the beginning of ’73 would be worth $104 by the end of ’76. By comparison, a $100 mix of 60% stocks and 40% bonds would have recovered to $119 by the end of ’76.
Loss Possibility Recovery Rate
This illustrates that the conservative portfolio of 80% bonds lost less and corrected faster, but over twenty years it accumulated about one-third less money than the 100% stock portfolio.
This grid is important to review carefully and ask yourself how you would feel in a major market downturn. Is it worth it to lose 32% if we stand a chance to have 50% more money in twenty years? Do we have twenty years left before retirement?
The figures illustrated above are based upon broad cross-sections and averages of American stocks and bonds. In an actual 401(k) investment selection, there will be a variety of investment types offered which will create more diversity and possibly less risk.
A mix of different types of stock market investments (including, for example, an international fund or small-company fund) will generally reduce the amount of loss in a market downturn while maintaining the same gains that would have been expected of the market as a whole.
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