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Dorothy Rosen -- The Dollar Diva Ask the Dollar Diva

401(k) allocation for twenty-somethings

Dear Dollar Diva,
I am 26 years old and have the opportunity to participate in my company's 401(k) plan with a 50 percent match.

My problem is not how much to invest, but where. There are 12 different mutual funds to choose from, including index funds, emerging growth, value, overseas, aggressive growth and bond funds.

At this point in my life, where should I allocate my money?
Vito

Dear Vito,
"Where should I allocate my money?" is the most important question an investor can ask. Deciding on an asset allocation and rebalancing your portfolio every year to keep the percentages where you want them are the keys to maximizing returns and minimizing risk.

Before you can decide on an asset allocation for your 401(k) plan, you need to understand the three main mutual fund categories:

1. Investment objective: Conservative or aggressive? Life's a trade-off.
Conservative investors trade lower returns for lower risk and preservation of capital. Owning bonds is less risky than owning stocks, and owning stocks in large U.S. companies is less risky than owning stocks in small, foreign companies. The older you get, the more conservative your investing should become.

Aggressive investors trade higher risks and periods of high anxiety for higher returns. With a lifetime of investing ahead of you, you can afford to take a more aggressive approach; but you have to stay the course. The stock market is volatile; when it takes a dive, you have to hold tight, believing it will follow its historical pattern of bouncing back and moving forward in the future.

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2. Investment style: Growth, value or blend?
Growth funds look for companies whose sales and earnings are growing faster than average; the stock price is usually expensive in relation to current earnings. In other words, the price/earnings ratio (P/E ratio) will be high.

Value style funds look for companies with stock prices that are cheap, relative to their current earnings. In other words, the P/E ratio will be low. Read the Diva's "What is value investing?" for more on this investment style.

Blend funds use a combination of investment styles.

3. Size of company: Large-cap, mid-cap or small-cap?
"Cap" means "capitalization." A company's market-capitalization is its share price multiplied by the number of shares owned by investors.

Large-cap funds invest in large companies; mid-cap funds in medium-size companies; small-cap funds in small companies. For more on this, read the Diva's "What is market capitalization?"

Before the Diva suggests an asset allocation for you, here are some comments on the specific funds you asked about:

Index fund
You need to understand what an "index" is before you can understand what an "index fund" is:

  • Index: An "index" measures and reports the performance of a particular group of stocks. It's a benchmark, or bogey, for the group it represents. The benchmark for most mutual funds is the S&P 500.
  • S&P 500 index: This index measures the total change in market value of America's 500 most widely held public companies. The goal of most stock mutual funds is to beat the S&P 500. Over the long haul, hardly any of them do, so an S&P 500 index fund is a good place to put your large-cap investment dollars.
  • Index fund: An "index fund" buys the same stocks that make up a particular "index." Vanguard is the 800-pound gorilla of index fund investing.

An index fund that mirrors the S&P 500 is a large-cap fund, holding a blend of growth and value stocks. Expect your investment in this type of fund to be boring, effortless and profitable.

There are indexes to measure every segment of the investment market. To learn more, read the Diva's "You'll need an index to do the job."

Emerging growth fund
An emerging growth fund buys stocks in companies in less-developed countries, such as Mexico, Malaysia, Chile, Jordan, the Philippines and Argentina. Because of the political and economic instability of the emerging markets, these funds are volatile and risky.

Overseas funds
Overseas funds buy stocks and bonds in foreign companies. Global funds have a mix of U.S. and foreign holdings.

Aggressive growth
Aggressive growth funds invest in companies whose sales and earnings are expected to soar in the future. These funds have periods of huge losses and periods of huge gains; you're betting that over time the gains will far outweigh the losses. You need a strong stomach and long time frame to invest in this type of fund.

Bond funds
Bond funds invest in bonds. A conservative fund invests in U.S. government bonds; an aggressive fund invests in high-yield or "junk bonds."

Suggested asset allocations

Aggressive

Medium risk

Conservative

Bonds

0%

20%

40%

Large-cap

55%

45%

35%

Medium-cap

15%

15%

10%

Small-cap

15%

10%

5%

International

15%

10%

10%

For more information on the various types of mutual funds, visit the Morningstar Web site. Morningstar is the leading provider of independent data, analysis and editorial commentary on mutual funds.

Do yourself a favor and use the free Morningstar "Quicktake Reports" to check out the mutual funds offered by your company's 401(k) plan. Among other things you'll learn the name and tenure of the fund managers, what fees they charge, investment styles, size of companies the funds invest in, performance data and risk/return ratings.

If this is too much information to digest before it's time to make your first 401(k) contribution, don't despair: Put the entire contribution in an S&P 500 index fund, or other large-cap, blend fund, until you've had time to decide what allocation you're going to feel comfortable with and what individual funds you wish to select.

-- Posted: Nov. 1, 2001

-- Posted: Nov. 1, 2001

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