August 5, 2008
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401(k) Asset Allocation
Now that I’m settled into my new job in California, I’m rolling over my 401(k) and looking at my asset allocation. Ooh, how interesting! Next week: statistics for advanced accounting. I’m going to outline my strategy here and invite critical discussion from my savvy readers.
I think of investments in four categories:
- Cash
- Bond
- Domestic Stock
- International Stock
It’s possible to subdivide each category, such as Small-Cap vs. Large-Cap stocks. But I don’t hold any theories on the different performances of such subdivisions so I’m lumping them together for the purposes of this discussion.
I have a separate IRA supporting Highrock’s mortgage. To keep things simple, I am leaving it there, where it earns 5%, tax-deferred. That counts as the Cash portion of my retirement portfolio, leaving me to balance my 401(k) across the remaining 3 categories.
I’m going to omit Bond funds from my portfolio entirely. In my opinion, the expected return on those funds doesn’t justify the increased risk from recent and continuing mortgage-based bond defaults. That leaves only Domestic and International Stock funds.
I believe in index funds. The majority of actively-managed mutual funds underperform their benchmark index, while charging higher maintenance fees. Why pay more for less? Along those lines, my other key metric is to minimize the expense ratio. So that leaves me looking for one Domestic index fund, and one International index fund. Fortunately, my 401(k) administration website allows me to run searches and dump the results to a spreadsheet. So I found the following funds which matched my criteria:
Domestic: VTSMX, tracking MSCI US Broad Market Index, 0.15% expense ratio
International: GIXIX, tracking MSCI_EAFE, 0.37% expense ratioI’m simply going 50% into each for both current funds and future allocation. Are there any problems with my logic or assumptions? For your own 401(k), do you pursue more sophisticated strategies, or less?
Comments (16)
My financial advisor makes a vigorous case against index funds. Her claim: index funds may perform as well as managed funds when the market is going up. But when it is going down, you want a managed fund. An index must hold onto a stock until it is delisted, even if it is completely clear the company is going under.
I’m still trying to figure out whether I buy this argument.
in my old days in the financial world, we would recommend index funds… bc it offers the diversification that gives you a better return in the long term. for your 401 (k) and at your age being on the more aggressive (or risky) side is ok. and for our 401(k) we try to keep it simple.
back before the tech boom crashed, i inadvertently had like 60% in defense contractor stock, so things were pretty decent–when everyone else lost like half their accounts, mine actually stayed even. since then i moved that ratio down to 20%, but i wonder, is that unwise as well? i’ve always viewed defense stock as something like bonds–since there’s only 2-3 major companies in the u.s., and we’re always at war with somebody, we’ll always have steady defense business…
i await the eagerly the final verdicts so i can rearrange…
in response to swanger, this just came across my rss reader (i haven’t looked at the original research so no particular comment either way): http://seekingalpha.com/article/89329-active-funds-not-better-in-a-bear-market
if you want to just invest in equities and you want to be capitalization-weighted (which is what you get from an index fund), you might consider figuring out what proportion of global equities the US makes up (and throw the rest in EAFE).
overall i like this plan cuz it’s brain-dead simple to implement. =P
i talked about the same thing in my Lazy Investing article and what i’m planning on doing, http://www.kimplicity.com/fkim/blog/2008/07/30/the-lazy-persons-guide-to-investing/.
in the end, who knows?
You might also want to look into Exchange Traded Funds. You can select an index fund, but they don’t have any management fees unlike mutual funds – just a fee to buy/sell, so is worth it if you are putting enough $$ into the ETF.
Swanger: I’m concerned about your financial advisor’s opinion. Does she have any data to back up her theory? Here’s an opposing theory: active money managers have only a 50% chance of guessing when a company is going under, so their bad guesses balance out their good ones. And then their higher fees and “cash drag” drop them below index fund performance.
About defense stocks: I don’t have any reason to believe that it’s a growth industry, so I’m not taking any measures to increase my stock weighting in that industry.
About US vs Global market cap: http://bespokeinvest.typepad.com/bespoke/2008/06/percent-of-worl.html
The US is at 30% right now, which argues for a 30/70 cap-weighted split. I will probably do that unless I can think of a reason not to weight International so highly.
About ETF’s: it looks like there are various pros and cons beyond the scope of my understanding:
http://www.investopedia.com/articles/mutualfund/05/ETFIndexFund.asp?Page=3
But my 401(k) choices don’t include any ETF’s, so that makes it easy for me to eliminate the possibility.
Someone also asked privately asked me: “Why MSCI US Broad instead of S&P 500″? Because I believe that diversification hits diminishing returns fairly quickly: the DJIA (30 price-weighted stocks) and the S&P 500 (market-cap-weighted) track each other very closely. And that MSCI US Broad fund has the lowest expense ratio of the US index funds that I can choose.
Unfortunately, the only data my financial advisor wants to point to is the fact that, over the last ten years, she has selected managed funds for me that, overall, have outperformed their indexes. But this is primarily because of NBGAX….
I can understand how it’s hard to both give up a fund which has outperformed the S&P over the past 10 years. And that it’s hard to end a long-term relationship with a financial adviser.
However, consider the following scheme to get rich by misleading people — as a licensed financial adviser. First, acquire N clients. Divide them into two equal groups, N1 and N2. Now choose 2 actively-managed mutual funds with high volatility; call them FUND1 and FUND2. Tell the clients in N1 to invest in FUND1 and the clients in N2 to invest in FUND2. A year later, let’s say that FUND1 has outperformed the index, and FUND2 has not. The N2 clients get mad and leave you (if they’re paying attention). Time to recruit new clients for N2! In the meantime, tell the clients in N1 how smart you are, and how fortunate they are to have you as an adviser. Rinse and repeat. Profit!
This is a variant of the Football Picks Scam, and it surprises me that it is actually legal. Frankly, I think prostitution is a more honest trade.
Oh, it’s not just the advisors. The banks themselves hire a bunch of fund managers, let them pick whatever they want (it may be random), and just fire the underperforming ones. As I understand it, they aren’t required to disclose how many funds they drop, and the ones that happen to outperform get high ratings. So the fact that a fund outperforms the index is no evidence that the manager knows what she or he is doing.
But there are, in fact, some smart investors out there (Buffett is an example). The question becomes: what are the chances that I’ve got one of those?
I agree, though, that if you’re just starting out, your chances of finding a good advisor are very low, so you’re better off going with an index.
index funds are fantastic…for developed markets. that means US, Canada, Europe, Japan.
index funds are not great for developing markets. some people believe that developing markets are in a current bubble…what do you think of China???
on cash, i would consider (1) what you mean by cash and (2) what currency you keep. in finance, cash generally means short-term governments…you can do better, with no dollar risk, using bank CDs. while you have no dollar risk, you still have inflation risk and currency risk – as we’ve seen gas/food prices are going up and the dollar keeps going down. for diversification, you might consider keeping cash in a foreign currency. Everbank, for one, will help you do that.
on your comment about not using bond funds, i can see your point because many people have been burned by MBS and widening corporate spreads. keep in mind, however, that the risk of any asset is dominated by its correlation with the rest of your assets, not by its own risk. …i can’t tell you what will happen to bond funds, but i can say that international equities and domestic equities have a high correlation that only grows higher as the world continues to integrate. …also, if you are really afraid of bad MBS, recall the many write-downs for financial firms…you wouldn’t want to hold these either.
In this period of volatility, you should probably have at least 10% cash. When you roll over your 401k, don’t immediately
use the balance to purchase your index funds, but scale in gradually instead. You can’t really predict market tops/bottoms but
if you buy your funds over a period of time, you’ll get the average price. Having some cash on hand always gives you some flexibility in that you’ll always be selling when you’ve got profits and buying when things go on sale
I don’t know about what kind of funds that you’re able to get in your 401k plan but definitely a general index fund is probably not the way to go – there’s definitely going to be pain in retail, banking, auto, housing, etc. Healthcare, consumer staples, energy, and machinery are doing well in the present and near future environment.
good luck!
Thanks for the comments. MSCI EAFE doesn’t seem to include China, for good or for bad. I guess once China is considered a “developed market”, their stocks will be added to the index. Foreign cash is an interesting investment, but outside the range of my 401(k) options.
I agree that it’s probably better to time-average my transfer into index funds for further diversification. But I don’t have the patience to do that (and I have some small limit of how often I can reallocate my 401(k) funds), so I guess I’m going to roll the dice and let the rollover happens when it happens, with a 1-time full transfer into the 30/70 domestic/foreign index funds. I could look more into specific markets (and I agree that with some research, I could make intelligent bets on certain sectors), but again I’m too lazy.
I am sitting on a good amount of cash in bank CD’s / money market, which is independent of retirement savings. It’s earmarked for a possible future house purchase. But the housing market would have to be a separate post in itself!
my professors believed that dollar cost averaging was a lousy thing to do…
it decreases expected returns (obviously). and, if done too slowly, it can actually increase variance.
Increase variance? The way I see it, the farther apart in time, the less correlation, which leads to lower variance. Unless you hit something cyclical (not white in frequency spectrum, but spiky).
“not white in frequency spectrum, but spiky”…. that’s no way to talk about faithetc.’s race!
[j/k!]
No advice here. I don’t have alot of options in terms of 401k in the new job. Did you actually have to rollover your 401k? I actually kept mine from MIT, since the 401k account for my new job is still with Fidelity. I also kept my MIT one, because it actually had WAY more funds from which to choose. With that, I put a portion in a “social responsible” fund, whatever that meant, perhaps just to placate to my ethical sense. Hmm, I think I should invest in some sort of alcohol, tobacco, arms, and prostitution fund, just to balance things out…
Oh, btw, SF was great! Many firsts…. like stumbling into a clothing-optional beach near the Golden Gate…. okay, the nudy part wasn’t so great, but the bridge and ocean views were spectacular! I felt like I was in a beach scene from some cheesy Korean drama with the wind all blowing through my sheer, white, rolled-up long sleeves, wave crashing, with seafoam bubbling just out of reach of my khakis, as I walk slowly along the line where the ocean meets dry land, looking longingly at the setting sun, dripping its last rays of……
Pardon, I was in a moment….