Chapter 1-3 Asset Classes

It is essential to comprehend the difference between the investments in your 401(k) account that have the highest risk and the lowest risk.  Once you do this, you can build a portfolio to obtain your objectives with a risk level that you are ready to endure.  Usually, investments fall into three asset classes that bear various levels of risk and return.  The first asset class is equities which include stocks, stock funds, and real estate funds (also known as REITS).  The main risks associated with equities are volatility and falling prices.  Fixed income is another type of asset class.  It includes bonds, bond funds, stable value funds, and guaranteed investment contracts (GICs).  The main risks of this asset class are default and changes in interest rates.  The third type of asset class is capital preservation which includes money market funds.  Inflation and changes in interest rates are the main risks of capital preservation.

By allocating your investments among the three main asset classes (equities, fixed income, and capital preservation), your 401(k) portfolio can meet both objectives of safety and growth.  Throughout history, stocks, bonds, and capital preservation not only generate returns in various ways, but also are apt to produce their biggest returns at different times.  A sample allocation for a younger investor is 80% equities, 10% fixed income, and 10% capital preservation (cash equivalents).  For an older investor closer to retirement, allocation could be 33.3% equities, 33.3% fixed income, and 33.3% capital preservation (cash equivalents).  Asset allocation signifies appointing a percentage of your total 401(k) portfolio to each asset class.  Consider the following pie charts illustrating sample allocations for a younger investor and an investor closer to retirement:


Your investing technique will decide what percentage of your portfolio you allocate to each asset class.  Based on your age, your other retirement assets, and your risk tolerance, your technique might be depicted as aggressive, moderate, or conservative.  Portfolios of younger investors seek growth by investing mainly in stock and stock mutual funds, regardless of the risk of short-term losses that they bear.  Moderate investors might invest anywhere between 40 to 60 percent of their 401(k) portfolios in stock or stock funds and the remaining portion in bonds, bond funds, or other fixed income investments.  Conservative investors address capital preservation by investing mainly in cash investments.

One of the most convincing defenses for asset distribution is that stocks and bonds are likely to respond in contrary ways to various economic conditions.  When bonds are up, stocks are likely to be down and vice versa.  If some of your 401(k) account is in each asset class, you are able to control your losses without surrendering possible gains.

After you’ve decided the percentage you are assigning to an asset class, you must determine how to invest the money that the percentage depicts.  It is important is to recognize funds that invest in various sectors of the stock market.  This can include large companies, small companies, growth companies, or companies that are prepared for a comeback.  You can also contemplate a balanced fund, an index fund, or an international fund.  This way you are in a position to profit from whichever of the market sectors are performing the best.  You can use the same technique for selecting bond funds; however, you may find that there are less bond funds to choose from within your 401(k) plan.  Consequently, you do not want to use all of the funds offered by your 401(k) plan because there is little advantage to having more than one fund that invests in similar assets.  The issue with spreading yourself inefficiently is that a little money goes into each of the funds making it difficult to accrue a significant account value.

Your investing approach should offer the growth that you want at a tolerable risk level.  As you get older, the growth that you want and your risk tolerance change.  Economic conditions and how your other retirement assets are performing will also change your risk tolerance and growth targets.  This is where reallocation comes in.  The asset distribution that fits you when you are/were 30 years old may not be suitable when you are 60 years old.  For example, if an investor is 30 years away from retiring their portfolio might be made up of 80% stocks, 15% bonds, and 5% cash.  When the investor is 12 years away from retirement their portfolio might be composed of 60% stocks, 30% bonds, and 10% cash.  As the investor approaches 5 years away from retirement his 401(k) portfolio might be made up of 40% stocks, 40% bonds, and 20% cash equivalents.


No particular distribution plan offers substantial results in all economic conditions.  If your employer’s pension plan assures you regular income when you retire, you may be more tolerable of investing your 401(k) account in a more aggressive manner than what is recommended for a person your age.  Similarly, if retirement is far off but evidence points towards a bear market, you could reallocate your 401(k) portfolio in a more conservative manner to secure some of the gains that you have accumulated.

You will want to look into your 401(k) account to see if it’s performing as you had expected it to.  Follow how your investments are performing and possibly reevaluate your asset distribution.  Your 401(k) portfolio takes work.  Your administrator manages the actual transactions in your portfolio, the recordkeeping, and the reporting, but you determine how and when to reallocate and rebalance your assets.  By checking regular account statements, account expenses, mutual fund quotations, and other resources you’ll have information that can aid you in monitoring and managing your 401(k) portfolio.

The importance of a retirement plan cannot be exaggerated enough because your long-term financial preservation will most likely rely upon the money you withdraw from your account when you retire.  Annual reports (IRS Form 5500) must be filed by employers and your plan manager must provide you with a copy of the summary annual report (SAR) if you ask for it.  You can also get copies of the SAR from the US Department of Labor (DOL) for a copying charge.  You should also receive a copy of your summary plan description (SPD), which is a document that outlines the rules, schedules, and procedures of your 401(k) plan.  You might have to ask for it, but your employer should also give you a copy of your individual benefit statement at least once every 12 months.  You may want to go over the details of the document with your financial adviser or you can ask your plan administer or the human resources department.  Even though some account statements are generally easy to understand, other documents may be harder to make sense of.

All 401(k) plans have asset based fees and expenses that have a direct effect on your investment return and your long-term financial preservation.  An essential part of managing your account efficiently is recognizing what those fees are, how they affect your return, and what the fees pay for.  It can be difficult to calculate how much the fees are going to cost you because you do not pay them personally; they are taken away before your return is accounted for.  Furthermore, the rate at which the fees are calculated and the amount you pay are not part of your account summary, most of the fees are clarified in your summary plan document (SPD).  You can also get a clarification from your human resources or personnel department.  If you find that the fees that you are paying are greater than the average, there is not much that you can do directly to lower them, but you can encourage your coworkers to unite with you in petitioning for a 401(k) plan that has lower costs.

In addition to a sales charge there are various types of fees that may apply.  One such fee is an administrative fee.  The plan administrator manages or arranges for the accounting, recordkeeping, and the legal services that are required by your 401(k).  The administrative fees cover these services.  The fees that you pay will differ depending on the size of the 401(k) plan, the plan’s provider, and the services that it provides members.  Typically, the bigger the plan the lower the rates at which fees are charged.  This is because the fees are being obtained from more people or because your employer has more power to bargain.  Some employers may also pay for part or all of the administrative fees.  Another type of fee is an investment fee, or investment management fee.  This fee typically accounts for the biggest part of the total fees and is paid on every investment in your 401(k) portfolio.  These fees may range from 0.02 percent to 2.5 percent or higher.  You may have to pay various rates within a single 401(k) plan depending on the investment decisions that you make.  Fees on bond funds are likely to be lower than on an actively managed stock fund.  Furthermore, the fees on index funds are generally lower than the fees on bond funds.  There are particular conditions that may carry investment charges.  One of these conditions is if you transfer money out of a fixed income investment.  You should also recognize that trading costs are generally additional fees, and not included in the investment management fees.  If a brokerage window is offered by your 401(k) plan, allowing you to trade stocks within the plan, keep in mind that you will pay a commission for every trade executed.  Another fee that that may apply to your 401(k) plan is a loan fee.  Contrary to investment fees, which are paid by all account holders, some fees are imposed on particular services.  Loan fees can differ from a small percentage of the total you borrow to a relatively large percentage of the total amount that you would be qualified to borrow.  The prospectus of the fund will contain a fee table.  You can search for more information on the costs that you will have to pay on the fee table.