Welcome to 401(k) Workshop, Part 5: Monitor Your Investments to Keep Your Wealth Growing. This is the final part of the series - I hope you’ve enjoyed it!
Your 401(k) is an incredibly powerful tool to help you build wealth, but it’s not perfect. Many people have expressed confusion and frustration with how to choose their investments, how much money they need in their 401(k), and an array of other issues. In addition, there are probably some unknown elements of your 401(k) that are working against your financial success!
This series provides a step-by-step process for evaluating your 401(k)’s purpose (it’s about more than just “save up a bunch of money”), understanding how your current financial situation affects your 401(k)'s future growth, and developing a plan for getting the most out of your 401(k) to better provide for your financial future.
A Southpaw with Right-Handed Clubs
My first experience golfing was one I’d sooner forget. I’m a southpaw, but the only clubs available to rent that day were right-handed clubs. This certainly didn’t help my confidence, but off I went. With right-handed clubs I had zero confidence that I would even be able to get the ball off the tee. I took my first swing and the ball took off through the air at least 150 yards!
I certainly haven’t turned into a golf prodigy since then, but it taught me something valuable. Having only right-handed golf clubs caused me to lower my expectations. I was relaxed and calmly swung at the ball.
Since my swing was with the opposite hand, it had little power behind it, but that didn’t matter much. Amateur golfers get themselves in trouble by swinging at the ball with all their might, which throws off their form and often sends the ball into the trees or the rough.
You’re Not Looking For Changes To Make to Your 401k
Monitoring your investments is the last step in the process of maximizing the potential of your 401(k), but it also tends to get investors into the most trouble. Like my golf experience, research suggests that the harder investors “swing” at their portfolios--like changing their investments based on their 401(k) funds’ daily or weekly performance--the worse their portfolios do.
The primary monitoring activity 401(k) investors should plan to do is an annual review of their investments. Implicit in that statement is the idea that you don’t even need to look at your 401(k) statement at any other time during the year.
I know a lot of investors who like to check the market's performance every single day. When they see an investment slump for a week or a month, they think the mutual fund has gone bad or their strategy is wrong, and they want to change it. These investors typically spend a lifetime moving money from one investment to the other with little success. In fact, after trading fees and the value of their time spent are accounted for, they’re usually worse off.
Monitor Your 401k Investment Plan by Rebalancing
Monitoring your investments should include regular rebalancing. Rebalancing means reviewing your previously determined investment allocation (from Part 4), selling a portion of the overperforming funds, and purchasing more of the underperforming funds to restore your previous investment allocation.
For example, let’s assume you owned the three mutual funds in column one with the investment allocation (based on your financial goals and risk tolerance) shown in column two. One year later, the US stock market has improved significantly, but international and US bond markets have taken a hit overall. Your new allocation is shown in the third column.
To rebalance this portfolio you would sell a sufficient portion of your ABC Large Cap Fund and use the proceeds to buy additional shares of the DEF International Fund and XYZ US Bond Fund in order to restore the 2016 allocation of 50/30/20.
The logic of this may seem counter-intuitive to a lot of investors, since you’re selling the investment performing well in order to purchase more shares of the losers. In a well-diversified portfolio, however, we have a reasonable expectation that investments have the potential to go up over long periods of time, so we take advantage of the “lower prices” of the underperformers by purchasing more shares.
I typically recommend rebalancing once a year and only if your investments have moved at least 5% above or 5% below your target allocation.
Monitor Your 401k Investment Plan by Adjusting Your Asset Allocation
Adjusting your asset allocation is the process of moving your investments from one fund class to another. In contrast to rebalancing, where you occasionally review your holdings to restore your allocation, changing your asset allocation is done at set periods of time, typically every 5 years, in order to gradually decrease the risk exposure of your portfolio. As mentioned in Part 4, target date funds make allocation adjustments for you automatically.
Here is a sample allocation for a 35 year old and a subsequently new allocation after 5 years. Notice that these are not significant changes, but rather a gradual, small shift away from riskier investments toward less risky investments.
For help determining your allocation each year, you could try using the Vanguard Investment Questionnaire we used in Part 4. Plug the data in to see what your allocation should be. It will likely suggest you change your allocation toward less risky investments as you get closer to retirement age, all else being equal.
Many 401(k) plan administrators offer their clients a much more comprehensive tool for determining what you allocation should be and making changes to it. If available, you’ll probably be better off using a tool through your 401(k) provider, as they will be able to pull in specific details about your account balance and current investment holdings, and make recommended changes.
It might also be worth your time to consult with a fee-only financial advisor for help to determine your asset allocation. An independent advisor can often take a less partial look at your situation and investment options and provide a less biased recommendation.
Circumstances When Other 401k Investment Changes Are Made
Besides rebalancing and asset allocation changes, there may occasionally be other situations where changes to your 401(k) investment plan is warranted.
They’re certainly not all bad. Perhaps you truly love the work you do and don’t see yourself retiring as soon as you thought. Someone who ends up pushing their retirement back 5, 10 or even 15 years would likely want to make adjustments to their allocation based on how much longer they’ll be in the workforce.
A pay raise or other financial windfall typically won’t affect your investments, but may change how much you’re willing to contribute (at least I hope that’s the case!) A bump in pay would serve you especially well if you used it as an opportunity to ratchet up your 401(k) contribution, rather than quickly allowing your spending habits to cozy up to your new-found salary boost.
Other life circumstances may rightfully lead you to either decrease your contributions or adjust your asset allocation. These may include the loss of a job, changes in your tax situation, or sudden changes to your family situation.
Overall, changes to your 401(k) each year will likely be minimal, if any at all. Remember the virtues of rebalancing, where you can effectively purchase additional shares at a lower cost, and the benefit of changing your asset allocation every 5 years or so in order to gradually shift your allocation toward less risky investments.