The investment options for your 401(k) account are typically a mix of stock funds, bond funds and perhaps a few alternative investments, such as real estate. If you concern yourself primarily with the choice between stocks and bonds, then your asset-allocation decision is primarily driven by two factors -- age and risk tolerance.
How Long Until Your Golden Years?
While every investors' financial circumstances will differ, it is common to take more risk at a younger age and reduce your risk as you grow older. Over the past 80 years or so, stocks have delivered returns of about 8 percent to 10 percent per year on average, but with much more volatility, and therefore risk, than bonds. Long-term corporate bonds or US-government bonds have yielded about 5 percent to 6 percent over the same period, but with less risk. One rule of thumb is to subtract your age from 100, and the resulting figure is the percentage you should invest in stocks. So a 30-year-old investor would put 70 percent of retirement funds in stocks, while a 60-year-old would have shifted to 40 percent stocks as retirement approaches.
Your Risk Tolerance
Most 401(k) plans have many options for both stock funds and bond funds, including corporate and government bond options. The other major part of the asset-allocation decision is your personal appetite for risk. While both stocks and bonds can rise and fall in value during the year, stocks have proved over time to be more volatile, and therefore a riskier investment. If the attraction of a higher potential return from stocks is overshadowed by your concern of potential loss, then you may be a candidate for moving more of your 401(k) investments to the bond allocation than your typical age profile would suggest.
While you are dealing with much lower figures, your asset-allocation decisions are not unlike what large institutional investors, such as pension funds and insurance companies, must make on a regular basis. Historically, these large, sophisticated firms tend to settle on a roughly 60-40 mix between stocks and bonds, outside of other types of assets. The primary reason being the desire to participate in the higher return potential of the stock market, but to moderate the overall risk of the portfolio with government and corporate bonds. Regardless, it is very important to diversify your portfolio, even within these broad categories, so that you are not over-exposed to a single company, industry or region.
It's Your Money
You have taken advantage of your employer's 401(k) plan, so you are already making a wise choice to control your financial picture for retirement. Consider taking a little more risk in your early years to reap the higher risk-reward offering of the stock market, and plan to move much of your investment to safer bond fund options as you approach your golden years. Finally, primarily use tax-advantaged bond-funds for non-retirement savings, as your 401(k) is already growing tax free and you would waste the benefit of such funds on this portion of your savings.
Frank Donovan has been working in the financial services industry for more than 15 years in consulting, sales and research roles. He runs client relations for a Boston-based financial research firm focused on asset allocation. Donovan has a Bachelor of Science in Economics from the Wharton School at the University of Pennsylvania.