Is Your 401k Heading for an Iceberg?

Managing your 401k can be simple with a little planning

Icebergs usually have most of their size underwater. Only the tip pokes through the water. The dangers to passing ships lie unseen under the water. There are also many unseen dangers when investing in your company sponsored 401k plan. Many individuals know that they are unsure about the investment selections in their 401k account, but that is just the tip of the iceberg. If you are making one of these mistakes your 401k could be heading for disaster.

If you are like most people, you pick your investments in your 401k by chance. You may just think, well I have 5 choices so let me just put 20% in each. Some people may just put it all in their company stock. Others may just go by past performance. All of these could be a mistake. These actions put icebergs in your path.

If all of these methods are mistakes, then what should you do to avoid the iceberg? Your first step is to figure out what your goals are. When are you going to retire? Today most people don’t fully retire, so instead of retirement, let’s call it ‘financial independence.’ This is the day you no longer have to work if you don’t want to. When I ask clients when they would like this day to be, they usually say “tomorrow.” Usually that is an unreasonable request. Make this date reasonable.

Once you know your timeframe, the next step is to understand your tolerance for risk. Here you will need to do some internet research. You can find many risk tolerance questionnaires online. MSN Money has a nice one you can find here. After you answer these questions, this will tell you roughly what type of asset mix you should have by showing you the percentage of assets in the different class types.

Since you now know what you should have, next you have to figure out what types of choices are available in your 401k plan. Sometimes the name can be misleading. There are many finance sites that can tell you what they are. Finance.google.com and finance.yahoo.com are my two favorites. On the Google site, you can type in the name on the list of choices and it will pull the symbol for you. Google will pull the Morningstar style box. You can use this to match the choices with the results of your risk tolerance questionnaire. The tough part comes when you have more than one choice in a category.

The mistake often made here is picking the assets with the best return. Remember this can be an iceberg waiting to appear on the horizon of your 401k. Usually the funds with the highest return can be the funds with the highest amount of risk. Use the finance site to figure this out. Both of the above sites will show the measures for risk. Look at the funds standard deviation and the funds beta to determine how risky they are.

The bigger the standard deviation the wider the swing in returns or the more risk. You want to find a fund with a good balance. The beta tells you how much risk the fund takes compared to the market as a whole. If beta is greater than one, your fund takes more risk than the market. A good gauge as to how effective the manager is at managing the risk is to look at the fund’s alpha. In simplistic terms, alpha is the grade for the fund manager. The higher and more positive this number the better.

Another iceberg waiting to happen is company stock. My advice to clients is to own no more than 15% of your company stock in your overall portfolio. This is not limited to just your 401k account. The reason for this is diversification. Generally most clients get a majority of their income from their employer. If you also have a big chunk of your net worth tied up in the company stock, what would happen if your company goes under? I won’t go into the stories of the Enron or Worldcom or AOL employees. You get the picture. It is best to use your company stock as a portion of your overall strategy. For example if your company is a large company, use your company stock as half or a quarter of your overall allocation to large cap companies.

Once you have your allocation in place, don’t mess with it for a year. Do not try to time the market. It will have ups and downs. That is normal. Review your risk tolerance after a year and determine if it has changed or the risk of any of the funds you have chosen has changed.

I have oversimplified this process, but hopefully following these steps will help you avoid any icebergs in the path of your 401k.