At Personal Finance, we have grown increasingly concerned with the national trend toward underfunded retirement plans. As a service to our subscribers, for the next few weeks we’ll send you a complimentary series of focused briefs to get you thinking about new ways to maximize performance both inside and outside of a structured 401k or similar plan. We hope you’ll find these briefs useful … if they are not applicable to your situation please click here to stop receiving the series.

In this second installment of a five-part series, we examine the vital importance of proper asset allocation for a successful 401k plan.

When flying an airplane, a pilot relies on myriad indicators in the cockpit to help make the right decisions to safely fly the plane. The indicators reveal direction, altitude, velocity, wind speed, fuel level, etc.

If one of the gauges is not within its proper boundaries, the pilot makes corrections to stabilize conditions. Without these dashboard indicators, the pilot would be putting his passengers and crew at serious risk.

Managing your 401k portfolio can be accomplished in much the same way. It requires a flight plan combined with an allocation dashboard. The process of developing your allocation dashboard will clarify your goals and methods for reaching them.

All too often, 401k investors don’t follow an allocation dashboard—which means they’re flying blindly. Because 401k plans are invested for the long haul, investors tend to shunt them to the back of their minds and neglect calibrating their holdings according to an asset allocation strategy. Over the years, that sort of neglect can dampen gains and increase risk.

Asset allocation is a continual process, not a one-time event. It is the process of selecting among disparate investment choices and combining them to achieve adequate returns while reducing volatility.

Asset allocation is one of the most crucial decisions in investing. Investors generate returns through three basic activities: selecting specific investments to buy; deciding when to get in and out of the markets; and establishing asset allocation.

The first two activities are the hardest and least forgiving. However, asset allocation is the easiest to determine—and it wields the most power.

According to financial industry studies, more than three quarters of portfolio performance and volatility is related to asset allocation.

An asset allocation policy entails dividing a portfolio’s investments among different asset classes. The most common classes are stocks, bonds, cash, and metals. Your allocation should be designed to provide an easy and transparent way for you to determine how your investments are performing.

Keep in mind, we’re not referring to market timing. A common misconception is that you must time the market to succeed with your investment goals. Not so. In fact, most investors who try to invest at “just the right time” do the opposite. They buy when the market has increased and is all the talk around the water cooler, and they sell when the market falls due to adverse political, economic and international events.

You should tune out the noise of the chattering class, as well as the market’s ephemeral ups and downs. Forge an asset allocation plan predicated on your long-range goals—and stick to it. Make adjustments but do so sparingly, as your circumstances and goals evolve.

To make a 401k plan really worth it in your younger years, you must emphasize stock mutual funds. The fact is, 401k plans are long-term money. And over the long term, stocks have outperformed every other investment vehicle.

If managed correctly, a 401k plan is the most powerful method of accumulating retirement assets over the long term. And stocks are the best long-term game in town.

Stocks have historically outpaced other types of investments because they provide the opportunity for growth. That’s why 401k investors have an advantage—they can approach the stock market with an eye on the distant horizon.

We’d never advise putting all of you eggs in one basket. But the younger you are, the more heavily you should weigh your 401k portfolio toward stock mutual funds. This emphasis on stocks should diminish as you get closer to retirement (see dashboard below).

Your Allocation Dashboard

Before establishing your 401k portfolio’s asset allocation dashboard, first answer this basic question: What’s your stage in life?

We suggest these age-contingent categories: relative youth (Starting Line—15 years from retirement); middle age (Mid-Race—5-15 years from retirement); and advanced middle age/senior citizen (Winner’s Circle—5 years from retirement).

The following dashboard encapsulates our suggested allocations:

 









Chose a category based not only on your approximate age, but also on your tolerance for risk. As long-term market history amply shows, you’ll have to withstand a lot of bumps along the way.

If your portfolio is heavily weighted toward stocks and the stock market takes a sharp turn for the worse when you’re 15 years or more away from retirement, you still have plenty of time to bounce back. That’s why our recommended allocations get safer, as you get older.

But remember: If you’re still several years away from retirement, the safer you play it, the less effective your 401k plan.

John Persinos is editorial director of Personal Finance and its parent website, Investing Daily. He’s also a senior analyst at 401k Millionaire.

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