When setting up your investment choices in your 401(k), you are typically presented with three main options: shares of your employer (if it is a public company), funds built up by market capitalization, and target date funds. Target date funds are investments that meet your projected retirement year. As you get closer to the target date, the fund automatically changes its holdings to become more conservative.
Term funds have grown in popularity over the past few years. According the morning star‘s Target-Date Strategy Landscape Report. Target date funds can be a good option for investors looking to take the hassle out of their portfolio, but they come at a price.
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Since they reallocate their holdings for you, target date funds tend to be more expensive than other index fund options. It’s not far-fetched to find a target date fund with an expense ratio of around 0.50%, which means it will cost you $5 for every $1,000 you’ve invested. While that may not seem like much, it could be tens of thousands in fees paid over the life of a 401(k).
Cut out the middleman
There are four main types of assets in a target maturity fund: US stocks, international stocks, bonds and cash. For stocks, most target date funds are “funds of funds,” which means they are made up of other, usually much cheaper, funds. Instead of paying the high fees that often come with target date funds, you can cut out the middleman and simply invest in what the target date fund holds. For a good, well-balanced retirement stock portfolio, 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 are generally more stable because they have more resources to their advantage. You probably won’t see outrageous growth from large cap funds due to their size, but they have proven to be more reliable over time. Small cap funds are at the opposite end of the spectrum. They are small businesses with high growth potential, but they are more prone to volatility and less likely to weather tough economic times. Mid-cap funds are the sweet spot: small enough for strong growth but big enough to carry less risk.
International funds are made up of non-US companies and should be in anyone’s portfolio. If you only invest in US companies, you are limiting your return potential and not being as diversified as you probably should be. A good rule of thumb is to have around 20% of your portfolio in international equities.
Manage your own stock reallocations
Adjusting your portfolio’s risk profile as you age is important for investing. You don’t want to take too much risk as you approach retirement in case something goes wrong (like a bear market) and you end up being unable to recover financially. In your younger years, the vast majority (if not all) of your portfolio will be in stocks. As you approach retirement, your portfolio will begin to incorporate safer assets like bonds and cash.
Fortunately, you don’t have to pay high fees to have funds reallocated for you; You can do it yourself. For someone in their 20s or 30s, you can take on more risk, so your allocations can be 80% to 90% in stocks with an allocation such as:
- Large cap: 50%
- Midcap: 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 remaining equity allocation broken down as follows:
- Large cap: 60%
- Midcap: 10%
- Small cap: 10%
- International: 20%
As you enter your 50s and the final decade before retirement, you want your large-cap stocks to lead the way. You still want to grow your money, but you also want stocks that are generally more stable and can at least help preserve what you’ve earned so far. Your portfolio can be made up of 40% to 50% bonds, 10% cash and the rest divided between:
- Large cap: 70%
- Mid Cap: 5%
- Small cap: 5%
- International: 20%
There is no one-size-fits-all approach to your allowances. You can start with these baselines, but it’s important to adjust them based on your personal situation and risk tolerance. You may be in your 30s and decide you are risk averse and prefer much less exposure to small cap stocks, or you may be in your 50s and comfortable with more high risk stocks and high yield in your portfolio.
Either way, do what makes you feel comfortable. By taking just a few minutes each year to adjust your allowances, you can potentially save yourself thousands of dollars over time.
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Stefon Walters has no position in the stocks mentioned. The Motley Fool has no position in the stocks mentioned. The Motley Fool has a disclosure policy.