When you set up your 401(k) investment choices, you’re typically given three main options: stocks from your employer (if it’s a public company), funds raised by market capitalization, and targeted funds. Target date funds are investments that serve your projected retirement year. As you approach your target date, the fund will automatically adjust its holdings to become more conservative.
Trust funds have grown in popularity significantly over the past few years. According to the data, in 2021 the total amount of investments in trust funds reached a record 3.27 trillion dollars (20% more than in 2020). Morning starLandscape strategy report due date. Target-date funds can be a good option for investors who want to manage their portfolio independently, but they come at a price.
Because they redistribute their holdings for you, target date funds tend to cost more than other index fund options. It is not far-fetched to find a trust fund with a date expense ratio around 0.50%, which means it will cost you $5 for every $1,000 you invest. While this may not seem like much, it can add up to tens of thousands in fees paid over the life of the 401(k).
Removal of the mediator
There are four main types of assets in target date funds: US stocks, international stocks, bonds and cash. When it comes to stocks, most mutual funds are “funds of funds”, meaning they are made up of other, usually much cheaper, funds. Instead of paying the expensive fees that often come with target-date funds, you can cut out the middle man and simply invest in what the target-date fund holds. For a good, well-rounded portfolio of retirement stocks, you only need four types of funds: large-cap, mid-cap, small-cap and international.
Large-cap funds are made up of larger companies that tend to be more stable because they have more resources at their disposal. You probably won’t see amazing growth from large-cap funds because of their size, but they’ve proven to be more reliable over time. Small-cap funds are at the opposite end of the spectrum. These are smaller companies with high growth potential, but they are more prone to volatility and less likely to weather tough economic times. Mid-cap funds represent the sweet spot: small enough for fast growth, but large enough to carry less risk.
International funds are made up of non-US companies and should be part of someone’s portfolio. If you only invest in US companies, you are limiting your potential for returns and are not as diversified as you probably should be. A good rule of thumb is to have about 20% of your portfolio in international stocks.
Engage in reallocation of your own stocks
Adjusting the risk profile of your portfolio with age is important to investing. You don’t want to take on too much risk before retirement if something goes wrong (eg bear market), and ultimately you will not be able to recover your finances. In your younger years, the vast majority (if not all) of your portfolio will consist of stocks. As you approach retirement, your portfolio will begin to include safer assets such as bonds and cash.
Fortunately, you don’t have to pay high fees to redeploy funds to a target date; you can do it yourself. For those in their 20s or 30s, you can take on more risk, so your allocations can be 80% to 90% in stocks with an allocation like:
- Large cap: 50%
- Average capitalization: 15%
- Small cap: 15%
- International: 20%
If you’re in your 40s, you still have about two decades before retirement, so you don’t need to get too conservative just yet. Your allocations can be 30% to 40% bonds with the rest of your allocation in stocks broken down as:
- Large Cap: 60%
- Average capitalization: 10%
- Small cap: 10%
- International: 20%
If you’re in your 50s and in your last decade before retirement, you want one large cap stocks lead the way. You still want to grow your money, but you also want stocks that are usually more stable and can help at least preserve what you’ve made up to this point. Your portfolio can be 40% to 50% bonds, 10% cash, and the rest split between:
- Large Cap: 70%
- Average capitalization: 5%
- Small cap: 5%
- International: 20%
There is no one-size-fits-all approach when it comes to your distributions. You can start with these baselines, but it’s important to adjust them based on your personal situation and risk tolerance. You might be in your 30s and decide you’re risk-averse and prefer much lower exposure to small-cap stocks, or you might be in your 50s and feel comfortable with more risky, high-reward stocks in your portfolio.
In any case, do what is comfortable for you. Taking just a few minutes every year or so to set up your distribution can potentially save you thousands over time.
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