by Jay P. Nicholls, CFA® | Director of Trading
and
by Kevin M. Perniciaro, CFA | Associate Trader and Research Analyst
Boston Financial Management’s Financial Life 101 Series is designed for the next generation of investors. Our goal is to empower and educate, so everyone, from novices to experts, can find the peace of mind that comes from understanding their financial options. Please share this commentary with anyone you believe will benefit from its content.
In our last Financial Life 101 commentary, we discussed how to determine which 401(k) was right for you. You may be left wondering, what’s next? The next step is to select how contributions should be invested. This can be a daunting task with so many possible investment options to choose. Most 401(k) providers will offer a long list of mutual fund choices with little explanation on what these are, or what they do. A mutual fund is an investment vehicle that will pool money from investors and buy securities like stocks, bonds, and other assets. This allows retail investors access to a professionally managed investment strategy and provides investment managers one pooled fund instead of having to manage individual accounts, creating a beneficial relationship. The fund investment style selections range from conservative to aggressive.
Before choosing which funds to invest in, it is important to understand the goal of your 401(k), which is to provide a source of income in the future that will support your living expenses in retirement. Through this framing, it is easier to understand that if you have a long time between now and retirement, you can afford to take on more risk in pursuit of higher returns. This is because you have time for your portfolio to recover from a decline in the market. Conversely, as the time to expected retirement decreases, so does your window to recover from market volatility. Thus, your 401(k) allocations should be more aggressive near the beginning of your career and slowly transition to more conservative investments over time. Lastly, one important rule to remember for long-term investing: time in the market is more important than timing the market. Investors often let their emotions control their portfolios, abandoning their financial plans at the worst times. We are human after all! That is why having a financial plan you can lean on during uncertain times is crucial.
Now let’s dive into some common fund types:
Aggressive:
This style will be more heavily invested in stocks and can be global or geographically focused. It may invest in companies of all sizes or focus on a subset like small, growth companies. Aggressive funds may have a higher expected return than a more conservative option, but that comes with higher risk.
Conservative:
As the name suggests, this style tries to mitigate risk by owning assets like high-quality bonds whose return are more predictable and safer but also expected to be lower than a more aggressive fund. It can serve as a diversifier to an aggressive allocation and provide capital preservation in times of uncertainty. While the investments may seem safer, the inherent risk in being too conservative is not saving enough for retirement. Your account needs to earn more than the rate of inflation to maintain purchasing power in the future.
Balanced Fund:
A balanced option will attempt to match the risk tolerance of a “moderate” investor by owning a fixed mix of stocks and bonds overtime. Balanced funds will range from more aggressive to more conservative, with the intention of providing a smoother return than aggressive funds while offering higher returns than conservative funds overtime.
Target Date Funds:
Many plans have options called target-date funds that select an approximate year for retirement and invest accordingly. These will be more aggressive in the early years (i.e. more heavily in stocks) and more conservative as the retirement date approaches (i.e. more heavily in bonds). It is an easy option for someone who wants to pick one fund and not have to adjust as their situation changes. However, they can come with high fees. In addition, since everyone’s financial situation is different, this style may not match your risk tolerance.
Active versus Passive Funds:
Active funds are managed with the goal of earning a higher return than a specific benchmark. Passively managed index funds are managed to track a specific benchmark. Both can be aggressive, conservative, or somewhere in between. Performance varies widely depending on the asset class, investment style, and benchmark. Active funds tend to come with higher fees than passive index funds and fees can be a drag on return over the long run. Often a combination of index funds can achieve the right mix of risk and return while keeping fees low so you can achieve your long-term goals.
Conclusion:
Determining where you fall on the Aggressive-Conservative scale will determine the appropriate mix of funds in your portfolio, and help you stick to your plan for the long run. This will help you avoid trying to time the market and keep you on track to achieve your retirement goals. It is also important to check in periodically, perhaps once a year, but avoid checking too often as it may tempt you to deviate from your plan. Beware of funds with high fees as they can reduce returns over time. Be sure to know what you are buying, because picking a fund without knowing the risks and return profile can lead to unexpected outcomes. These decisions may seem overwhelming at first but it’s rewarding to watch your nest egg grow over time.
The team at Boston Financial Management is always available for retirement planning questions. Please do not hesitate to contact your Wealth Manager directly or call our main line at 617-338-8108 and someone from our team of specialists will be happy to speak with you. If you enjoyed this article, and have other topics to suggest, please let us know.