401(k)s and Asset Allocation

The Three Main Classes of Investment Assets

To get a good understanding of how we may use asset allocation to manage our 401(k) account, we need to first look at what types of choices are possible. This is not about picking one stock fund over another at this point, as we’re deciding what percentage of our portfolios we want in each of the major classes at a given point in time, with stocks being all part of the same class.

It is typical for our 401(k) to offer more than one class of investments, so this is not about choosing funds at this point within the same class as much as it is about what distribution we want to have among these classes. The three classes are growth, income, and savings.

There are some people who just pick a certain asset allocation and stick with it through thick and thin, preferring to not make any decisions at all about their portfolio and let it manage itself basically, perhaps in fear that they might make mistakes. While mistakes can certainly be made here when managing asset allocation, if we know what we are doing, we can really help ourselves.

401(k) plans are administered by our employers and while they all offer a limited amount of choices, we’ll presume here that our 401(k) offers access to all 3 asset classes, by way of stock funds, income funds, and cash funds like money market and what are called stable funds. If we do not have access to funds in the savings class, this will really limit what we’re able to do, and some 401(k)s don’t have any options here, but many do.

The returns for savings class funds are pretty low, and people tend to look at the long-term performance of them and think that this does not fit their investment objectives very well at all, which is actually true. This isn’t a good use of this type of asset though, and what we want to be doing instead is using these funds in a more tactical way to manage risk.

We’re All Seeking Long-Term Growth

Growth funds are widely promoted by investment advisors because they do tend to achieve one’s investment objectives all by themselves. Why go with something that might give you 2 or 3 percent return over time when you can shoot for 6 or 7 percent?

The reason why this choice isn’t as easy as they may make it has to do with the component of risk. Growth funds that are unmanaged have the highest risk of the three classes, and everyone knows that stocks can both go up more and go down more than bonds or savings funds.

We might think that we can simply set our investment horizons far enough out there that these normal ups and downs of the market will be allowed to play out, and the longer-term up trend that we see in markets will end up prevailing. This may end up happening, but there is always a risk it won’t, as well as the risk that when we cash out, we may do so during one of these downtrends.

When our time horizons shorten, even though the long-term upward trend may continue, we’re going to have less and less of a chance to have our timing match it. If we have 30 years to go, we can be reasonably certain that we will have a good positive return, although far from completely sure. If this time gets reduced to 20 years, 10 years, and 5 years, we become less and less likely to achieve our goals, and therefore the risk for us keeps going up.

Some people think that if their investment time horizon was 30 years when they started investing, then somehow this remains the case throughout one’s life, but this is big mistake. We need to look at how many years we have left in our time horizon, not how many there were when we first started, which is actually meaningless.

This is why we are told that we need to reduce our risk exposure as we approach retirement, and it’s actually because our risk goes up every year that we get closer to needing to take money out of our 401(k) accounts. Predicting market movements and being on the right side of them can be done on any timeframe, but if we’re using a completely passive approach with no risk management, and the basis of this is the long term, as the term shrinks this will be less and less likely to achieve our goals.

Imagine that we just have a year left before we need to take our money out. We have it all in a stock fund, and at this point it is not a matter of things going up over the long term, because we no longer have the long term to rely on.

If we’re going to be deciding what to do, to stay or to go with part or all of these funds, we’re going to have to be able to determine where the market is heading over the next year, and continue to monitor this as the time remaining plays out.

This is not something that typical investors have any idea about, and they really won’t get any real help from their investment advisors either, who aren’t trained at all in such things. This is also much more difficult to do than predicting 30-year trends and such.

If we do have the ability to manage our accounts in these shorter timeframes, we can take control of things and continue to pursue the bigger growth potential of stocks while managing the risk sufficiently, but in the absence of this, we’re going to have to get out of this market and into more safe investments.

If we were looking to buy a fund and told our advisor that our time horizon was only a year, they would hopefully not sell us a stock fund, and the right advice would be that we don’t have the time to take on the risk of a growth fund and have any reasonable expectation that we would not be down money in a year.

This would require us to monitor the market conditions, and in a strong bull market for instance, we would be doing ourselves a disservice to choose something with very paltry returns over something that probably will do much better, but we don’t generally look at the market at all when deciding this or any other investment decision. When we don’t, then not taking on the risk of investing blindly like this over such a short time period is actually pretty wise.

Timeframes of investments are dynamic and always change with each passing year, and we always want to use our actual timeframe, the amount of time left. While we may revisit this periodically, we’re usually just told to stay the course no matter what, no matter what the market does and no matter how much time we have left.

While we may choose to stay the course generally, to just buy and hold, as time goes by, we need to continue to examine this in light of how much time we have from here, and only stay in this strategy when there is enough time left for it to remain reasonable, if we’re not going to hedge this properly that is.

Passive vs. Active Hedging

We are also told that we may wish to hedge the growth portion of our portfolios by allocating parts of it to other asset classes, mostly bonds. The idea here is to reduce our risk overall by making the potential downside smaller. If all of our money is in stocks for instance and the stock market tanks, we’re taking the full hit, but if we have half of our money in bonds, this will cushion the blow since bonds don’t move down as much as stocks do.

What makes this a passive style is that market conditions are not taken into account when these decisions are made, and we instead look to one’s age, one’s time horizon, and one’s risk appetite to arrive at this allocation.

We do tend to be too aggressive here generally, and people are told things like we should still hold a lot of money in stocks well into retirement, without either any regard to market conditions or to one’s ability to take on the added risk of stock investments.

The less time we have, the more we need to manage our risks, and while we can do so with a passive style, we do need to make sure that we’re managing these risks well enough. With a passive approach, this should actually have us steering well clear of growth investments in the later years of our life simply because we do not have the time anymore to ride out bear markets with a hold approach.

With active hedging though, we can allocate our funds depending on market performance. If stocks are performing best, we can go with more stocks or even be all in with them, but as other asset classes perform better, including the savings component when both stocks and bonds are underperforming them, which we see in some bear markets, we’ll seek to go with the best performing asset class at the time.

This does go against what might be called the prime directive of investing, which is to ignore market performance completely, as we’re told that this is somehow beyond the knowable, even though we see market trends unfold before our eyes and even may wish we heeded these signals instead of stubbornly staying the course come what may.

What we’re really after with active hedging isn’t to clobber the market like some traders do by moving in and out of things frequently, we’re just looking to reduce our market risk by moving around our money within different asset classes to avoid excessive losses during the larger trends against us, when this is actually occurring, when this is indicated.

This might have us deciding to make these moves every few years, and we might stay with an allocation for 10 years or more, depending on the market. We might end up staying with more conservative allocations for a number of years as well, if we are stuck in a bear market, and some can last for quite a long time.

While some of our friends may bemoan the big percentage losses that they experienced with their 401(k) funds during a bear market, if we are more adaptive with our hedging, we can step in and make these changes during the earlier phases of the pullback and reduce our losses.

The shorter our investing horizon becomes, the more important active hedging becomes, and especially when a buy and hold strategy is clearly not appropriate at all. We can just get out of stocks at this point as a passive strategy would require, at least if we are hedging properly that is, or we can continue to seek the larger returns that stocks can provide while being much more careful about the timing of these investments.

Even in a 401(k), with its very limited investment choices, this does not mean that we’re stuck being exposed to maximum market risk on the downside and can’t do anything to reduce or manage it. We can re-allocate our investments according to our risk exposure instead.

Managing risk is central to successful investing, whether this be in a 401(k) or anything else, and while we do want to shoot for good returns over time, it’s only sensible to look to manage the risk side of things appropriately as well, because there is a lot on the line here, our financial future.