Asset allocation is the process of placing your money in a range of investment vehicles, using the concept of hedging to protect against losses in any one area. A 401(k) account allows an investor to break up his invested capital and spread it among several fund options, providing a convenient way to manage personal asset allocation. In 401(k) accounts, you have a wide range of investment choices including stocks, bonds and real-estate investments, and the optimum mix depends on your personal preferences and prevailing market conditions.
Stocks often make up a large percentage of a 401(k) balance, but there are various types of stock investments from which to choose. Different mutual funds are focused on growth stocks, blue-chip or dividend-paying stocks, domestic or foreign companies, and sector-specific holdings such as technology-company stocks. Different stock-focused funds present graduated levels of risk that can be appropriate for various age groups and risk tolerances. Investors between ages 18 and 35 are often advised to favor higher-risk, high-return investments such as small-cap growth funds or funds focused on emerging markets. As the theory goes, younger investors can afford greater risk because they have many years ahead to rebuild their portfolios if high-risk investments do not pay off. Investors with fewer years until retirement are advised to favor safer stock funds focused on well-established, dividend-paying domestic companies.
Bonds represent debt obligations held by corporations or government entities. Corporate bonds can be broken up into the same categories as stocks since they generally originate from the same companies. Municipal bonds, Treasury securities and other government-backed debt generally offers a more stable, yet lower, return. You can use these public debt securities to hedge against a higher-risk investment such as a small-cap growth fund.
Mutual funds focused on real estate present distinct opportunities and risks compared with other stock and bond funds. Most real-estate funds invest heavily in real estate investment trusts, which sell shares to fund their investments in residential, commercial or industrial real estate. These funds can also hold stocks and bonds of real-estate developers, construction companies and other real estate-focused companies.
Choose funds that invest in a range of counter-cyclical market segments to mitigate the risks of any one segment falling in value. In real estate, for example, look for funds that invest in both new-home construction and rental housing, because each segment tends to gain strength as the other weakens. Consult your 401(k) prospectus or online investor portal to view the holdings in each fund. Some 401(k) providers even go as far as listing the market segments in which each fund is invested and its percentage of the fund.
Invest in at least three funds in your 401(k), always looking for hedging opportunities. You should always have money invested in both safer and higher-risk funds, but the allocation depends on your risk tolerance. For example, safer investors should keep at least 10 percent of their money in a high-risk fund to provide opportunities for growth, while high-risk investors should keep at least 10 percent in safer funds to balance their risk of loss. According to CNN Money, one general rule is to subtract your age from 100 and set the percentage of stocks in your portfolio equal to the difference, with the remaining funds going into bonds and other low-risk investments.
How to Change Your Fund Composition
Changing your asset allocation should be a quick and simple process, depending on your provider. You can most likely change your allocation by logging on to your investor portal and re-entering new percentages for each fund in an "asset allocation" section. To move money from one fund to another, replace the old fund's percentage with zero and set the new fund's percentage to your chosen amount.
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