How to build a better 401(k)

0
190


In a recent article, I proposed what I think is a dynamite investment strategy, especially for young people accumulating money for their retirement.

The idea is simple: Use a target-date fund for the core of your long-term portfolio, and give it a performance boost by investing a gradually decreasing percentage of your money in a small-cap-value fund.

I believe that combination, done properly, has the potential to add millions of dollars to the resources you will have after you retire, without adding much risk.

Read: These three investment products will help you build a portfolio for life

Since I presented this, I’ve received a lot of feedback and questions from readers. Here are some of them with my answers:

Q: You make a strong historical case for small-cap value investing. But isn’t it possible that this asset class has seen its best days? Do you really think they will continue to be big performers in the future?

Paul Merriman: First and most important, nobody can know the future of any investment. I’m very good at “predicting” the past, but I’m no good at seeing into the future.

Yes, it is certainly possible that the glory days of small-cap-value investing are behind us. But just about anything is possible. What’s more important is what is probable. And for that, the past is the best guide we have.

Read: Should you have your entire 401(k) in a target-date fund?

Over long periods, small-cap value stocks have an excellent track record of outperforming the S&P 500 index














SPX, +1.48%












 and just about every other major asset class.

The reasons are well-known. First, small companies have lots of room to grow big. Second, value companies by definition are bargains. Their prices haven’t been bid up by a general agreement that their futures are bright.

Those reasons are just as valid today as they have been for the past 90 years. I don’t know of any reason to believe this asset class has lost its potential.

Read: 5 ways target-date funds let investors down

Q: Is it reasonable to apply your two-funds-for-life approach using different allocations for buckets of money that have different purposes? For example, I have a pool of money I expect will support our retirement and another I expect we won’t ever need, and it will be available much later for our kids to inherit.

PM: You are on the right track. Money that won’t be needed for a long time can be invested more aggressively than money you expect to need sooner. The two-funds-for-life approach makes it easy to apply different allocations.

My wife and I have different allocations for different purposes, and we are already doing essentially what you are proposing.

Q: My wife and I are in 401(k) plans that have target-date funds, but they don’t offer small-cap-value funds, so it’s not easy to implement your suggestions. We can invest in small-cap blend funds, but only ones that are actively managed. Should we use these, or just stick to target-date funds?

PM: That is a tough call. Over the long haul, a small-cap blend fund is likely to boost your return. But the extra expenses and uncertainty of active management are likely to reduce that advantage. And if the small-cap blend funds are heavily weighted to growth, that could erase the small-cap advantage.

Here’s a better idea: Use your 401(k) plans for target-date funds and use your IRAs to own a small-cap-value fund or ETF. This lets you invest in exactly the fund you want.

There are two disadvantages to this arrangement. First, it will be difficult, if not impossible, to rebalance an IRA with a 401(k). Second, every time you get an IRA statement you’ll be confronted with the ups or downs of that small-cap fund. You’ll need to learn to view it as a component of your overall portfolio instead of an investment with performance to be judged independently.

Q: I’m in my 20s, and the target-date funds have glide paths that already include bonds, which I don’t really need at this stage in my life. Can I postpone the target-date funds until I’m 40 and in the meantime invest in an S&P 500 fund and a small-cap value fund?

PM: This is a good option. If you eliminate bonds until you’re 40, I think you can expect that to boost your overall returns by 0.5 percentage points a year. As you suggested, at age 40 you can replace the S&P 500 fund with a target-date fund.

Q: I like the idea of your two-fund strategy, but I don’t have 40 years. My wife and I are in our late 30s, and most of our retirement money is in the target-date funds offered by our companies’ 401(k) plans. How much benefit do you think we’d get by adding a small-cap-value fund at the level you are suggesting?

PM: It’s impossible to know for sure. But if you make that change, your portfolio will have a higher percentage in equities, and the equity part of your portfolio will have more exposure to small-cap stocks and to value stocks.

Each of those three changes brings with it an expectation of higher returns, along with higher risks. If you follow the recommended percentages in my strategy, these changes will affect only a minority of your portfolio, and that proportion will gradually decline as you age.

To answer your question directly, with a number, I think it’s realistic to expect an extra 1 percentage point in return. Over your remaining lifespans, that can make a huge difference in the resources you’ll have once you retire.

Q: Your research is impressive, and you make a good case for having two funds for life. But I’m nervous about taking past returns and projecting them into the future.

PM: Sometimes it’s reasonable to be nervous. I myself am conservative by nature, and I don’t believe in being casual about the way your money is invested.

So to address your nervousness, from one cautious investor to another, try this on for size: When we look at all the 40-year returns since 1928, we find that the worst 40-year return for small-cap value stocks was almost as high as the best 40-year return for the S&P 500.

Based on 90 years of history, that’s enough to overcome my natural caution. Only you can determine if it’s enough for you.

Q: Your study assumes monthly rebalancing, but that seems like too much busywork to me. Can I get the benefit by rebalancing just once a year?

PM: Yes, it may be unrealistic to expect most investors to rebalance their accounts every month, and some 401(k) plans might not allow that.

Once a year should be fine, letting the higher-performing asset build up its value. My friend Chris Pedersen, who did the research on this, estimates that annual rebalancing would add about 0.2 percentage points of return, with slightly higher risk as well.

As I wrote in my previous article, I offer three additional resources online to help you dig into this strategy.

First, Chris wrote a detailed article, illustrated with some interesting tables and graphs, and you can find it here.

Second, Chris and I recorded a video on this topic. And third, I recorded a podcast as well.

Richard Buck contributed to this article.



Source : MTV