How to Invest Your 401k

Last week we talked about the pros and cons of utilizing a 401k, so if you’re still not sure whether you should take the plunge check that article out first.

In this article we will look at some strategies you can take to improve your long-term returns if you have chosen to use the 401k provided by your employer.

Obviously, there is no free lunch.  None of these strategies are guaranteed to produce returns or to work for you.  Some 401k plans have limits on trading that will cut down your ability to actively manage them.  Before you pick one of the below, find your 401k materials and read over it.  Better yet, memorize it.

First, Find Eligible Mutual Funds

About half the time I help friends invest their 401k I go into the exercise hopeful that I will be able to talk about the pros and cons of investing in small-caps vs. real estate vs. a total market index, only to come unglued when the majority of fund offerings charge 2.5% annual fees.

This fee burden will kill any advantage you gain using a 401k.  Over time the loss of compound interest you pay out for the privilege of active, and sometimes even passive, management erodes the tax advantage, the match from your employer and likely even the behavioral benefit of being forced to save.

Set a fee rate hurdle above which you will not invest.  I become wary of funds with fees above 0.50% and refuse to participate in those with fees above 1.00%.

It’s possible doing this will cut out every fund except the S&P index, if that happens you can still time the market and use your 401k as part of a bigger strategy.

Though the provider is required to provide information on the fund, you may find that taking the symbol and typing it in on Morningstar.com provides better and more updated info, including the moving average info we will use for trend stats below.

Time The Market

We’ll start off with the most time-consuming, but also most fun strategy. I dedicated the final chapter of my recent book to value-based and trend-based factors that can be used to time markets.  If you really want to get into the nitty gritty, the book is the place.  It’s only $2.99 so you might as well get it.

  • Stocks
    • Value – Use CAPE (cyclically adjust price to earnings ratio) and set a value for buying, holding and selling. For example, you would start buying into the fund when the CAPE is below 12, stop buying in at 20 and sell at 28.  I don’t think the numbers/metric matters a whole lot – you could use p/e or p/book or p/sales.  The key is being consistent and disciplined.  If the market has fallen 50% and everyone is selling but the system tells you to buy, you must buy.  If the opposite is true and your neighbor is bragging about the biotechnology robotics stocks he’s up 300% on you must still sell.
    • Trend – Buy when the market price is above the 200 day moving average and sell when it is below.
    • Combination – Buy when the CAPE is below 20 and the price is above the 200 dma and sell when the CAP is above 30 and the price is below the 200 dma.
  • Real Estate
    • Value – Look at the distribution yield for the portfolio. For those familiar with commercial real estate investing this is the cap rate.  For those who are not, the distribution yield is simply the dividends paid out to you as a percent of the price you pay.  The higher the rate the more undervalued the real estate is.  Buy when the rate is above 4% and sell when it’s below 2%.
    • Trend – Buy when price is above 200 dma and sell when price is below.
  • Bonds
    • Value – Buy when the yield-to-maturity is above 6% (for the definition of this term and many other financials terms, my newsletter has a finance glossary that is updated weekly), sell with the YTM is below 3%.

Create an Effective Asset Allocation Strategy

If you are one of the lucky few with tons of low fee options in your plan you can set the allocations to create a strongly diversified portfolio.  You can ether choose to set the allocations only when the money is invested or you can check up on the portfolio each year and reset the allocations to keep the percentages stable.

The simplest way to do this is to invest equal allocations into each of a stock, international stock, real estate and bond fund.  The majority of plans I’ve looked at have an option in each of these areas.

To get more complicated you can allocate the US stock portion to the small-cap fund which likely has higher long-term returns or to the large-cap funds which will likely have lower volatility.  If there is a natural resource fund of any sort you can adjust the allocations to put 20% in each.

I would recommend avoiding any actively managed funds and, again, the key is picking a strategy/allocation and sticking to it.  If you allow biases and emotions to overtake you at every turn of the market you will end up selling low and buying high.

Using the 401k as Part of an Intelligent Asset Allocation Plan

For those with a limited selection of eligible funds or who simply want to save more than the percentage of income that is sent to a 401k, an ideal way to sue the plan is to invest in the S&P index or the bond funds as part of a bigger portfolio strategy.

For example, if your total savings including brokerage accounts, CDs and the 401k totals $1mm, the 401k totals $50k and you need a 20% allocation to the S&P just use the S&P index in the 401k as part of the that 20%.

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