Investing for success in your 401(k) plan

A principal drawback of target-date funds is their one-size-fits-all approach. "It assumes everyone who has the same retirement has the same risk tolerance, which is dead wrong," says Walt Woerheide, professor of investments at The American College in Bryn Mawr, Pennsylvania, which offers education and certification programs for individuals in the financial services industry. "For most people, asset allocation should be based on discussions with a financial planner."

Index funds and actively managed funds

Using index or actively managed funds allows investors to make their own asset allocation decisions. Given that active managers generally underperform their indexes and that index funds are cheaper than actively managed ones, some advisers favor index funds.

Actively managed mutual funds in the large-cap blend category carry an average annual fee of 1.21 percent, compared with 0.57 percent for index mutual funds, according to Morningstar. Some index funds cost much less -- in the 0.1 to 0.2 percent range.

Heyman recommends index funds for the large-capitalization stock portion of your portfolio, because most actively managed large-cap funds generate returns close to their index while charging a higher fee. "For small-cap and international choices, that's where I'd use actively managed money," he says. "You can get more value added there."

Some advisers are extremely critical of actively managed funds for their underperformance and high fees. Woerheide places them last in desirability among the three options in a standard 401(k) account.

But Benz says it is possible to find funds that beat their indexes. She compares it to choosing a restaurant. "Just because the average restaurant isn't that good doesn't mean that you can't select a good one."

One point investors in actively managed funds should keep in mind is that there will be periods when the fund underperforms, Benz says. Often people sell their fund shares after a period of weak returns, just before the fund bounces back.

How to invest your 401(k) money

A strategy that some advisers recommend would be to use index funds as your core holdings, with larger amounts allocated to them. Then you might invest smaller amounts in actively managed funds to round out a diversified portfolio and enhance your chances of beating the index.

In a twist of this strategy, Heyman suggests investing in an index fund for the large-cap portion of your portfolio, and using actively managed funds for the small-cap and international portions. Read Bankrate's story "How to choose mutual funds like a pro" to determine if the active funds in your 401(k) lineup are worthy of inclusion. Investing in a bond fund is a tricky issue right now, with yields near record lows.

Perhaps the biggest mistake investors make with the funds in their 401(k) account is trading them too much, financial advisers say. "A typical strategy is for someone to take a lot of small gains, and then one loss wipes out all the profit," Heyman says.

Most advisers say that you should stick with your investment plan, taking time once a year or so to rebalance your portfolio to achieve your original target allocation to stocks and bonds.

Another problem among investors who choose actively managed and index funds, according to Benz: They often don't "give enough attention to asset allocation. They don't think about their age and number of years until retirement," which should influence their fund choices, she says.

As you approach retirement, you should dial down your exposure to stocks and make capital preservation a priority.


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