How to Become an Educated 401(k) Investor

Investors in 401(k) plans face a tough challenge: They must choose the best investment products from their plans (choices are often limited to mutual funds) and manage these holdings as a portfolio.

This is extremely difficult for those who lack fundamental knowledge of investments. Indeed, many individuals who are highly financially literate, even chief financial officers, aren’t able to choose the best funds, in the right combination, for their particular situations.

Federal rules require companies to provide workers with extensive information about their 401(k) plans and the investments within them. But the overwhelming majority of workers have trouble understanding this information, much less using it to make suitable investment choices. This confusion often leads to participants choosing either a target date (age-based fund), which can be the most expensive type, or choosing a money market account that doesn’t earn net returns.

Too few employers provide actual financial education, and even fewer do so effectively. As a result, the majority of 401(k) plan participants don’t get the education they need to make good use of their plans. Here are some ways to bridge this education gap:

• Encourage your company to provide in-person or webinar education sessions. This isn’t as far-fetched as you may think. Though top company executives have retirement benefits that the rank and file doesn’t, these same executives are often participants in 401(k) plans. Thus, the brass share some interests with the rank and file.
• Absent the delivery of this kind of education from your company, seek out information from the websites of your plan provider, which is often a large mutual fund or insurance company. Plan participants might as well take advantage of what their plan providers have to offer, because they’re paying these providers fees out of their accounts.
• Consider hiring a financial planner on an hourly basis to help you select mutual funds from your plan’s offerings and structure them in the right amounts to meet your goals, within your capacity for risk. This can often be done with a couple of hours of consultation.
• Do your homework to find objective websites that provide investment knowledge — not those that try to sell visitors financial products. Examples include Brightscope and Financial Engines. These are far preferable alternatives to consulting fellow employees or friends who claim to have investment knowledge. These people are best avoided because they probably don’t know any more than you do regarding investing and asset allocation.
• In acquiring investing knowledge or guidance independently, seek familiarity with the concept of portfolio diversification — that is, including different types of investments in a portfolio to reduce risk from severe drops in value of any one type. Diversification is the basic idea behind asset allocation — deciding what investments to own and how much of each relative to other types.

To assure enough diversification in your investment choices from your plan and construct a suitable asset allocation that protects against risk, it’s essential to become familiar with some basic investing principles.

These include:

• Risk tolerance. Investment choices should reflect your particular tolerance for risk or potential loss. Risk tolerance questionnaires can be found online on various financial sites, and completing them will give you insights you can apply to portfolio construction. A free questionnaire can be found on the Morningstar site.
• Volatility. There is inherent volatility of stocks as compared with bonds. Stocks carry more inherent risk than bonds, so if you have a high risk tolerance, you may feel comfortable with a portfolio largely composed of stocks. By contrast, those with a low risk tolerance need to have more of their total investment dollars in bonds and fewer in stocks to protect against damage from stocks’ tendency to be volatile — to move up and down in value. Stock market volatility is a key reason why asset allocation is so important. Volatility interrupts compounding, the dynamic that delivers wealth growth. Appropriate allocation helps to protect against volatility’s negative effects. The more aggressive you are, the more stocks you should have. The more conservative you are, the more bonds you should have relative to stocks. Investors should match up the percentage of their portfolios they have in bonds versus stocks with their risk tolerances.
• Mutual Fund styles. Equity-based mutual funds are often categorized by the size (market capitalization) of the companies they own (large, mid or small companies), their style (the fundamental approach they use) and their underlying stocks. Value mutual funds hold stocks that are typically undervalued and likely to pay dividends. Growth funds hold stocks where capital appreciation is the primary goal; these aren’t expected to pay dividends. Some mutual funds employ a blended approach, investing in both value and growth stocks. These styles, which can be researched free of charge on Morningstar (a mutual fund-rating company) are often approached using a style box, which depicts each style relative to the others.
• Understanding different fund styles is critical to portfolio diversification. For example, you don’t want to have too much of your total investment in mutual funds in large companies, because these large companies may register share-price declines because of factors common to them. If that happens, and you have enough investment in small and midsize companies that aren’t affected by these same factors, this can buoy your portfolio’s value.
• Avoiding expensive mutual funds. One of the biggest problems with many mutual funds is that their high expenses cut deeply into net returns — the money investors get to keep after expenses have been taken out. Expenses are expressed in terms of basis points: 100 basis points equal 1 percent, 200 basis points, 2 percent, etc. Desirable funds have low expenses and deliver good absolute performance — that is, performance against their benchmarks, such as large-cap funds’ performance relative to the S&P 500 index of large-cap stocks.

In my opinion, funds with expenses totaling 60 or 70 basis points are low-expense, and those with 100 basis points and up are high-expense funds. Many 401(k) plans are replete with these high-expense funds. It’s the job of 401(k) investors to seek the highest-performing funds with the lowest expenses. (There tends to be a correlation between the two.) Companies sponsoring 401(k) plans are required to disclose mutual fund performance and expenses to participating employees.

By learning these basics, 401(k) investors have a much better chance of getting good long-term results and achieving financial security in retirement.

Any opinions expressed here are solely those of the author.

Gary Droz is managing director of MainLine Private Wealth in Pittsburgh and Wynnewood, Pennsylvania, and has worked in financial services for more than 30 years. He previously served as president and managing director of Innovest Financial Management, and co-founded the Senior Insurance Institute, which presented educational symposia throughout southeast Florida with the goal of educating seniors and addressing advanced life insurance issues. Droz has a BA in communications from the University of Pittsburgh. He has been a guest lecturer at the Tepper School of Business at Carnegie Mellon University, where he discusses the discipline of investment management.