Chapter 1-2 Range of Investments

The range of investments accessible in your 401(k) will be based on who your plan provider is and the selections your plan sponsor executes.  Understanding the various kinds of investments will aid you in building a portfolio that most fits your long-term objectives.  One of the most significant, and terrifying, choices you have to make when you join in a 401(k) plan is in what way to invest the money you’re contributing to your account.  The investment portfolio you select decides the rate at which your account has the possibility to grow, and the income that you’ll have to withdraw when you retire.

The average 401(k) plan may offer between eight to twelve investment alternatives.  It may be only mutual funds or a combination of mutual funds, guaranteed investment contracts (stable value funds), company stock, and variable annuities.  Some 401(k) plans offer brokerage accounts.  This signifies that you can choose investments from the abundant range of stocks, bonds, mutual funds, and other kinds of resources instead of having to select between the plan’s alternatives.

Each 401(k) plan lets you choose how to invest the contributions you make.  Some plans may even let you determine how to invest the matching contributions from your employer, but other plans let the employer make that decision, which includes the right to supply the matching contribution in company stock.

The more alternatives you have, the harder it may be to select the appropriate ones for your investment goals and risk tolerance.  It is your responsibility to discover how the alternatives differ from one another and what they each could add to your portfolio.  The general agreement is that the more alternatives you have; the more control you have over the degree of investment return you can gain.

Mutual funds are the most common 401(k) investments.  They attract a large range of investors for many reasons.  Three of these reasons are that they are diversified, they are liquid, and they are professionally managed.  Being liquid simply means that you can sell shares whenever you want, even though you can have a loss if the fund has slipped in value.  There are three wide categories into which mutual funds fall into.  The first is Stock Mutual Funds, which purchase shares of stock in publicly traded corporations.  The second is Bond Mutual Funds.  Bond mutual funds purchase bonds issued by public corporations, by federal, state, and local governments and by federal agencies.  And the third is Money Market Funds, which purchase an array of short-term investments from an array of sources.

When you acquire the list of funds that are offered by your 401(k) plan, you’ll most likely see an abundance of stock and bond funds.  There may also be a few balanced funds which hold both stocks and bonds and also a few index funds.  You may also have the option of selecting a target date fund, also known as a lifecycle fund, or managed account.  Each alternative has its own investment goals, management technique, risk level, and fees.  It is important to read the prospectus before investing in a fund.

When going through the different funds offered by your plan, consideration should be given to selecting funds with different objectives, risks, and management style to diversify your 401(k) portfolio.

The type of fund offered most and in more varieties by 401(k) plans are stock funds.  It is a fact that more than 67% of 401(k) assets around the nation are invested in either stocks or stock funds.  The main reason being that stocks and stock funds have historically beaten other kinds of investments over the long term, even though they don’t guarantee a positive return.  In the short term, the overall returns on stocks can be up or down, with most funds losing value when the market goes down.

401(k) plans usually offer a wide variety of stock funds that differ from conservative funds, which are less risky to your investment, to moderate risk stock funds, to higher risk funds.  Conservative funds, which include equity income funds and growth and income funds, focus on companies that are established and pay a consistent dividend.  The goal of this type of fund is stable yet sometimes limited growth in value, and limited risk from large losses emerging from the failure of a business.

On the contrary, aggressive funds invest in promising, younger companies that fund managers presume will be greater in value in the future than it presently is.  Investing in these funds comes with higher risk because there is an increased chance of these companies failing.

One of the things you must investigate when selecting a fund is the level of risk.  This is because most of the time the name of the fund doesn’t signify the level of risk that it offers.

Stock, or equity funds, invests in many different ways.  If you are given the option, it is better to select two or three funds that consist of different types of stock rather than focusing on funds that invest the same way.

One of the major differences is between growth funds and value funds.  Growth fund managers search for stocks whose prices they anticipate to go higher as the products or services of a company reach a broader market and their earnings increase.  Value fund managers search for stocks perceived as undervalued because the company or the sector in which it is traded is seen as undesirable by investors.  When the economy is weak, value funds perform better than growth funds most of the time.  But not every company can rally from a reversal or setback and regain the interest of investors.

Size is another major difference between stock funds.  Large-cap companies are more constant and less exposed to significant losses than small-cap companies.  One of the more prominent reasons being the significant financial reserves lag-cap companies have.  On the contrary, small and mid-cap companies can have more possibility for growth.

Some plans may also offer sector funds, which focus on a specific sector of the economy, such as financials or energy, or contrarian funds, which invest in stocks that are being ignored by investors.  Some plans may also offer international stock funds, which are funds that invest in companies that are located outside of the United States.

Many 401(k) plans also offer index funds.  These funds are a favorite option among investors.  An index fund is devised to mirror the performance of a particular market index, like the S&P 500.  An individual may favor index funds over managed funds, if they believe that there is no chance that a mutual fund manager can consistently outperform the market over the long term.

Additionally, the fees for index funds are more likely to be lower, and at times considerably lower, than the fees for managed funds.  The reason for this is that the decisions to buy and sell are entirely based on changes in the makeup of the appropriate index, therefore eliminating daily investment decisions or research.

One of the risks of using these funds is that when a market is down, the index fund will decrease in value together with the index that it mirrors whereas a number of managed funds may perform better.  Still another risk is that many indexes aren’t as diversified as they appear to be because an index is usually weighted, which means that a small number of stocks may decide which way the index will move.

Another type of fund offered by 401(k) plans is bond funds.  They provide interest income from the primary investment in the fund’s portfolio.  The interest income earned is reinvested to purchase more shares.  Distributing a part of your 401(k) contribution to these fixed income investments can have an important function in developing a diversified portfolio, decreasing investment risk, and aiding you in accomplishing your long term goals.

There are two ways to tell bond funds apart.  The first is by the kinds of bonds the fund owns and the second is by the term of the bonds in the fund.  In most cases, 401(k) plans offer five types of bond funds.  One type of bond fund is a US Treasury Bond Fund.  These funds invest in bills, notes, or bonds distributed by the federal government.  A second type of bond fund is an Agency Bond Fund, which invests in bonds that are financed by a group of mortgages and distributed by agencies of the federal government or government-backed enterprises.  Municipal Bond Funds are another type of bond fund.  They invest in tax-exempt bonds distributed by cities and states to subsidize public projects.  A fourth type of bond fund is a US Corporate Bond Fund, which invests in bonds that are distributed by companies in the United States.  Still another type of bond fund is an International Bond Fund.  This type of bond fund invests in bonds distributed by corporations that are based outside of the United States or by governments other than the United States.

The general maturities of the bonds in a bond fund can be classified as short-term, intermediate-term, or long-term.  Short-term funds have an average maturity of one year or less.  Intermediate-term funds have an average maturity of two to ten years.  And long-term funds have an average maturity of ten years or more.  The longer the maturity of the bond fund, the more susceptible it is to changes in interest rates.  The NAV, or Net Asset Value, of the fund drops as rates go up and the NAV increases as the rates go down.  What is most important from an investment outlook is the total return of a bond fund.  The total return consists of the interest that the underlying bonds pay, which is then reinvested to buy more shares, and any increase or decrease in the value of your capital.  The bigger your total return, the better your investment is performing.  There is more potential in a long-term bond fund than a short-term one to produce high total returns when interest rates are going down.  On the other hand, when interest rates are going up, the total return is more apt to decrease.  High-yield funds are the most volatile bond funds.  They invest in low-rated bonds with the biggest risk of default.

The most diversified mutual funds are balanced funds.  These funds invest in stocks, bonds, and preferred stocks.  The combination of these assets allow for both current income as well as possible growth.  Balanced funds are more likely to be less volatile than stock funds or bond funds.  The biggest disadvantage of balanced funds is that it is more likely to underperform stock funds in a bull market.  This is because only a part of the fund’s assets are invested in stocks.  The average stock portion is explained in the fund’s prospectus.  It is usually 60% of the total portfolio.  Also explained in the prospectus are any limits that the fund manager must ensue.  The performance of a balanced fund can also be affected by any changes to the current interest rate, most notably if the fund is invested in long-term bonds during a time when interest rates are rising.  This will more likely decrease the total return of the fund.  You may discover that a balanced fund is the QDIA, or Qualified Default Investment Alternative of your plan if you were automatically enrolled in your employer’s 401(k) plan.

Numerous employers offer lifecycle funds, or target date funds as alternatives for a 401(k).  These funds usually make investment strategies based on a target retirement date (for example, 2020 or 2030).  Lifecycle funds invest in various types of investments.  Some of these types of investments include domestic stocks, bonds, international stocks, and money market investments.  They are selected based on the date in which an individual will need to use their money.  The lifecycle fund will heavily emphasize stocks or stock funds the further away the date is.  As the date of when you will need your money draws near, the investment allocation will become more emphasized toward fixed income or fixed value investments, which contain among other things bonds or bond funds and treasury securities.  This steady change towards more conservative investments is created to decrease your risk as retirement draws near.

The set target date is essential to deciding the way your contributions are distributed among the types of investments in the lifecycle fund.  When the date is further into the future, a bigger percentage is invested in stocks, which traditionally have a higher growth possibility.  With this also comes a bigger possibility of risk to your principal.  But the aim is that you have time for the market to return to being profitable and possibly higher gains in the next market phase.  As time goes by, and you head closer to retirement, the assets are slowly changed so that there is a bigger importance on low risk bonds or capital sustainment.  Although this distribution isn’t going to generate the level of growth usual of a portfolio which is stock-heavy, it will more likely be less volatile.  This reduces the losses that your portfolio may endure, but it doesn’t eliminate them.  This is substantial because your recuperation time is shorter.

Lifecycle funds that have the same target date aren’t all the same.  Funds can differ considerably from one provider to the next.  Some lifecycle funds select assets that are somewhat aggressive, with most of the assets invested in stocks even as the target date nears.  Other lifecycle funds however, have a more conservative blend.  All of this information can be found in detail in the fund’s prospectus.

The alternative of investing your 401(k) assets in a managed fund may also be available by your employer or your employer can select this QDIA (Qualified Default Investment Alternative) if you are enrolled in the plan automatically.  In a managed account, your 401(k) is invested in a portfolio of diverse mutual funds or maybe individual stocks that are selected by a professional investment manager.  Managed accounts are comparable to actively managed mutual funds.  This is due to the fact that both have managers who adhere to a particular investment style, fluctuating from aggressive to conservative.  They pick stocks that suit a specific objective (for instance, long-term growth or income for retirement).  Contrary to a mutual fund manager, the accounts investment manager overlooks many accounts that are related but not exactly the same at the same time.  And will usually make the same transaction for all the accounts or most of them.

The managed account portfolios differ, as do those of lifecycle funds, so that there’s a bigger importance on growth using stock or stock funds in the portfolios for younger employees.  The portfolios of employees who are closer to retiring place a bigger importance on fixed income investments, including bonds and bond funds.

A lot of managed accounts have one manager who adheres to a specific investment style.  Others have many managers with varying investment styles.  When this is the situation, the assets are divided among the numerous managers, much the same way that a portfolio is divided among differing asset classes.  An advantage of this style is that if the total value of your 401(k) portfolio is still small, you’ll still be mostly divided and diversified.

Contrary to specific mutual funds or lifestyle funds, with a managed account you may have some control over the definitive mix of investments in your portfolio and when that mix is redistributed.

Some funds are created to protect capital, like stable value funds and guaranteed investment contracts (GICs).  This means that they make investments that have a low risk of losing money.

Stable value funds assure the value of your money, which is your beginning investment, and assure a fixed rate of return.  They may purchase US Treasury and corporate bonds in addition to interest-holding contracts from banks and insurance companies.  On the other hand, all of the fund’s assets may go into GICs (guaranteed investment contracts).  GICs are insurance company products that look like individual bonds or CDs.  This is because the issuer has use of your money for the term of the contract, and pays a fixed rate of interest in return.  Although it is very doubtful that a stable value fund will lose money, it has occurred.

Stable value funds and GICs pay a higher rate of interest than money market mutual funds.  This is one of the reasons many investors who wish to diversify a 401(k) account that includes more volatile investments, like stock funds, may select these funds.  Nevertheless, the interest rate on a stable value fund or GIC is guaranteed in most cases for only a fixed time, sometimes as short as three months, and differs with adjusting market circumstances.  Furthermore, if you want to move money out of the account, you may have to pay a penalty, which can be a substantial one.  This is not the case when you move money from a stock or bond fund into another investment.  The big disadvantage of capital protection alternatives is that they’re less apt to offer long-term protection against inflation, which can be a big problem because you do not want to discover that you have insufficient money that you need in retirement.

Your 401(k) plan may also offer variable annuities as well as mutual funds as investment choices.  If the plan provider is an insurance company, the plan itself can be a variable annuity.  A variable annuity is a combination insurance company product, which blends various funds that look like mutual funds with insurance protection that assures that at least your beneficiary will get your money back if you die before beginning to collect benefits.

In a variable annuity your contributions are divided between the subaccounts that the annuity offers.  Each subaccount has an investment goal and makes investments to meet that goal.  Your earnings rely on the investment performance of the subaccounts you select and the plan the company utilizes to credit any gains or losses to your account balance.  Variable annuities have some proponents that note insurance protection as a defense against losing money.  But detractors argue that the price paid for this insurance protection makes variable annuities more costly to own than mutual funds making much the same investments.  Still others argue the need for insurance in a long-term savings plan.  Detractors also argue that many variable annuities bring greater management fees than mutual funds do, which would increase the cost and decrease your return.

Although there is common agreement that variable annuities are elaborate products, detractors argue that they are often defined in a language that is difficult to understand that is likely to deemphasize the costs while overemphasizing the advantages.

Some 401(k) plans offer brokerage accounts, also called a brokerage window.  With a brokerage account you can invest in stocks, bonds, mutual funds or other investments that are offered by the brokerage firm managing the account.  You give buy and sell orders in the same manner as you do with a typical, taxable account.

Supporters of this technique believe that having the greatest likely selection is the way to let experienced investors have the opportunity to achieve the biggest likely return on their retirement savings.  If you sell a stock or bond that you’ve obtained through a 401(k) brokerage account for more than you bought it for, you won’t owe capital gains tax on the profit, but you will owe income tax when you withdraw from your account.  This is because the complete account is tax-deferred.

Some are concerned that having unrestricted variety can be complicated or intimidating, and that employees may not have sufficient information to make astute decisions.  Though, in almost all cases, plans offer a list of funds from which you can select as well as the brokerage window.  Detractors also argue that investing through a brokerage window might invite shareholders to buy and sell over and over again, attempting to better the market.  This process is known as day trading or market timing and is different from the long-term objectives of a retirement savings plan.

A 401(k) brokerage account has an annual fee, ranging from $25 to $175, contingent on the brokerage firm the plan utilizes.  There can also be transaction costs and commissions on each trade you execute through the account.  Fees on mutual funds you purchase through the account may also be higher than on funds that are part of a plan list.

If you are employed by a publicly traded corporation, your 401(k) investment list may include company stock or a fund that purchases only your company’s stock.  Recent events show the risk of relying too much on any sole company for your financial protection, but your employer may provide incentives that are hard to turn down.  You may discover that your employer encourages you to select this alternative.  In some instances you may be able to purchase the stock for a price that is lower than the current market price.  You may also be able to contribute a bigger percentage of your salary if you’re purchasing company stock, or your employer can match a bigger percentage of your contribution if it goes into company stock.

Employers can also select to make any matching contributions in stock instead of cash.  If this occurs your account is credited with shares of stock or shares in a company stock fund and it does not matter how you invest your personal contributions.  There are financial benefits for your employer in making matching contributions in stock.  This is because the company does not have to put out money, although all of its matching contributions are tax deductible.

Providing company stock as an investment selection gives employees the incentive of partial ownership beneficial to building up their commitment to the company.  It also offers a way for employees to partake in the profits if the company succeeds.  On the other hand, if employees have most of their 401(k) money in company stock, their long-term financial protection is at a much bigger risk than if they had diversified their portfolio.

There are two important decisions that you are confronted by if company stock is one of your 401(k) plan alternatives.  They are: Should I invest in company stock? And how much of my 401(k) portfolio should I allocate in company stock?

Besides any possible financial incentives that your employer may offer, there may be other advantageous justifications in selecting company stock.  You could make a significant profit from owning company stock if you work for a sound company in a market sector that is strong.  However, there may conceivably be serious problems.

You should not disregard the point that you are subsequently relying on your employer for your current income, because you would be restricting your financial protection all the more to one primary element.  In a worst case scenario, you could find yourself out of a job and the share of your 401(k) portfolio allocated to company stock could become completely useless.  Experts do not always agree on how much company stock to allocate to your 401(k) plan, but many favor 10 to 15 percent.  Also, you may have less freedom to alter the distribution of the assets of your plan if some of your cash is invested in company stock.  A 2006 federal law requires companies to allow employees to sell company stock they acquired through an employer match after holding it for three years.  This could culminate in losses if the price of the company stock declines before the time limit ends.  Nevertheless, some companies may allow you to sell shares of company stock acquired through an employer match right away.

In deciding how to build your 401(k) portfolio, there are various circumstances that should be taken into consideration.  These include your age, your risk tolerance, and other assets that you have invested.  For the most part, your retirement savings should yield strong long-term growth at a level of risk that is tolerable.  With a wide range of investment alternatives commonly offered by plans; sometimes 100 or more, deciding the right ones to select to aid you in accomplishing your objective can be a challenge.  That is why it is so important to distribute your assets and diversify your 401(k) portfolio to accommodate your long-term objective of yielding income for retirement.

Usually, the younger you are, the more you are able to take a risk, but as retirement approaches, the less risk you can sustain.  As retirement draws near, the more of your 401(k) portfolio you should want to switch into investments that are created to safeguard your financial assets and yield regular income.

Your risk tolerance may rely upon your own inclinations or how many years until your retirement.  If you are more inclined to take the risk that the value of your 401(k) portfolio will go up or down with the markets, the more you may invest in stocks or stock mutual funds.  The less risk that you are able to take; the more you may want to focus on investments that are created to provide regular income return.

If you have deferred annuities, pensions, individual retirement accounts (IRAs), taxable investments or any other retirement assets; you should keep in mind the overall outlook before determining how to invest your 401(k) account.  If say, your other retirement assets are distributed to more aggressive investments, you may want to invest your 401(k) portfolio in a more conservative manner to even out your risk.

Another factor that you should take into consideration is your tax bracket.  This may help you decide how to distribute investments between your taxable and tax-deferred savings plans.  If you invest your retirement accounts in investments that pay interest, you will be able to defer tax on the income earned until you withdraw it from your account.  Keep in mind, withdrawals from tax-deferred savings plans are taxed at your regular rate.

When you invest you are always taking a risk, but not all investments hold the same risk level, or even the same kind of risk.  When people hear the word risk, they usually associate it with a possible loss of capital.  But the risk of investing in insured assets presents the likelihood that your rate of return won’t exceed the rate of inflation.  This means that your account balance may accumulate over time, but your buying power might decrease.

The two major categories that risk falls into are portfolio risk and investment risk.  Various factors are partly responsible for investment risk, which is the possible loss in the value of individual investments.  One such factor is company risk, in which the value of a stock goes down as a result of internal problems within the company or investors changing their opinions about the company’s products or services.  Market risk is another factor.  This is when the total market value of the stock market or bond market goes down, taking with it most investments.  The values of bonds or bond funds go down as a result of changes to the interest rate.  This is known as interest-rate risk.  Another factor is credit risk.  Credit risk is when bond issuers stop making regular interest payments or fail to pay back principal once it reaches maturity.  Another risk associated with individual investments is currency risk.  This is when exchange rates rise and fall influencing the value of investments outside of the United States.

As with individual investments, there are various factors that contribute to portfolio risk.  One of these factors is inflation risk, in which investments that are low-risk and have low returns fall short of outperforming the rate of inflation.  Diversification risk is another factor that contributes to portfolio risk.  This is when the money in your portfolio is distributed in insufficient investments and they go down in value.  Another factor is employer stock risk, in which retirement savings are connected too closely with the main source of income, causing one to go unfavorably if the other does.  Still another factor associated with portfolio risk is time-horizon risk.  This is when you redistribute your 401(k) portfolio over time to give you an appropriate counterbalance of growth and income to fulfill your retirement objectives.

However, risks are likely to be recurrent, with one risk acting as a major threat during some time periods, while posing very little threat during other times.  So you do not encounter all of these risks with the same investment at the same time.  For instance, while market and company risk have had a strong adverse effect on the values of stocks in the last few years, rising interest rates have not been a risk.

In determining risk, you should take into consideration the liquidity of the investment, which is the ease in which the investment can be bought or sold.  Stock in large corporations can always be sold at the current market price, although you may lose some money if the price has gone down since you purchased the stock.  On the contrary, real estate is not liquid because you must wait to procure a buyer and reach a price.

A fundamental rule of investing is that there is a direct link between risk and return.  Making investments of differing types and levels of risk can aid you in positioning your 401(k) portfolio for growth as well as stability.  Just as important is putting together investments that bear varying risks, which may help you to endure economic turmoil, and can aid you in protecting your money and benefit in opportunities for growth.

Because you usually assume stocks will increase the value of your retirement account faster than investments that are less volatile, you may be inclined to take the risk of losing money on stock, stock mutual funds, and other equity investments.   Throughout history stocks have usually yielded a return that is almost double that of bonds over the long term even though at times there are significant short term losses.  But this is not the case for every individual stock or stock fund.

Adversely, conservative investments that lower your risk by guaranteeing your money and a lot of the times the return that you realize will in most cases offer more prudent rewards.  The biggest risk is that these investments won’t offer you the long-term growth that is needed to raise the value of your account.  This is particularly true during times of high inflation, where the rate of return can be lower than the inflation rate.  Some of them may even charge higher fees or set penalties, like stable value funds, fixed annuities, and guaranteed investment contracts (GICs), if you wish to move money out because you reconsider the rewards offered.

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