Retirement Portfolio: 401k Investment Strategy

Finding a good 401k investment strategy is an important decision that will impact you for numerous years. For most, their 401k's will be the mechanism used to reach their financial independence. Accordingly, proper allocation of investments into a 401k is crucial.

My friend and I were discussing 401k investments, when it struck me.  Most people think that investing takes a true Financial Engineer (pun intended).  At this point, I realized I wanted to share my simple, passive 401k investment strategy.

Please, do not take that out of context.  Investing can be complicated.  Some investor's strategies are extremely complex.  For example, hedge fund managers utilize engineers to analyze various financial instruments. They use stochastics, simulations and analytics as tools to asses an investment's risks and rewards.

Whoa, that is a fun word to say....stochastics.

As previously stated, my strategy of choosing investments for my 401k is not complex.  The approach I use provides 3 things.  First, it avoids actively managed funds. Second, it provides a broad market exposure. Lastly, it keeps costs low (low expense ratio).  Most importantly, I want to hold my 401k investments for the long-term.  In other words, play the long game.

In this post I will go through how I structured and planned my 401k by:

1. The 4 major classes of funds
2. The percentage of 4 classes in my portfolio
3. Rebalancing the 4 classes by age
4. Keep the 4 classes' costs low (low expense ratio)

Now, lets take a look at the 4 major classes of funds I invest in.

The 4 Major Classes of Funds

Simplicity is the name of my game.  Although there are numerous ways to structure a 401(k), my main focus is in 4 major classes.  They are as followed:

1.  U.S. Stock Index Funds

I remember first asking, what the heck is a U.S. Stock Index Fund and how does it work?  The best way I have found to answer this question is through simple pictures and metaphors.  For example, envision handing a single individual money to purchase a small share of every company listed on the S&P 500 index. This individual reaches out to every CEO that makes up the S&P 500 index.  They request each CEO place a share of their company in a box.  This box is a metaphor for the U.S. Stock Index Fund.  The individual that manages the box is a brokerage firm, like Vanguard.

You now own a small share of every company on the S&P 500 index, which lies within your box.  You will receive dividends from those companies that will automatically be used to purchase more shares of each company. The brokerage firm will place those additional shares back into your box.  This box will keep housing more and more shares until it is full (i.e. you reach your retirement goal), or you reallocate your money to a different investment type.

2.  U.S. Bond Index Funds

Envision purchasing debt from numerous municipal governments, companies, and the federal government through a single individual (the brokerage firm).  All of the varying entities' debts comes in the form of bond notes.

The individual will hold all of these notes in a box, similarly to the U.S. Stock Index Fund example. The box holds varying debt from numerous corporations or government branches. The individual will manage the box for you.  That person will ask each entity to repay you, with interest, until the debt is paid back in full.  The money returned to you can be reinvested or reallocated.

3.  International Stock Index Funds

Similarly to U.S. Stock Index Funds, international index funds allow an investor to own an entire box of international stocks that are not U.S. based. Instead of owning a portion of every S&P 500 company (or similar U.S. stock index), you own a small portion of international companies.

The individual will still reach out to every company for you.  Similarly to the U.S. Stock Index Funds, that individual will request every company place a share in the box (the International Stock Index Fund) that they will keep for you.  The individual that manages that box is still a brokerage firm, like Vanguard.

4. Real Estate Investment Trust (REIT's) Index Funds

Similarly to all of the previous index funds, the Real Estate Investment Trust (REIT) index funds seeks to follow an entire REIT Index.  The box will now hold numerous REIT's and companies that manage properties that collect rent.  This box will reflect a total REIT index that will be managed by a single individual who will reinvest your returns.

If you are not yet aware, I am a huge proponent of index funds.  This diversifies your portfolio at the cheapest cost (low expense ratio).  Rather than investing in a single sector, index funds allow you to own the entire markets in a box.

Next, I will share the current percentage that makes up my 401(k).

The Percentage of 4 Classes in My Portfolio

As most of you know, I am relatively early in my career.  As a 30(ish) year old father of 2, I still have a way to go before I retire.  Although I plan to be financially independent through passive income streams, I will not retire until my early 50's.  This is a strategic plan to better support my two daughters.

With that known, I am in a growth model of my 401k retirement plan.

Rebalancing the 4 Classes by Age

I currently plan to follow the 120 minus my age(ish) to allocate that portion of my 401k portfolio to stocks.  This would mean when I turn 40,  I would have 80% of my 401k in U.S. Stocks.

As I continue to gain grays in my hair, and get closer to my early retirement age I will decrease my risk exposure in stocks and place them into U.S. Bonds Index Funds.

Once I reach the retirement age where I can take distributions without penalties, I will further lower my risk exposure and shift even more of my money into U.S. Bond Index Funds.

Finally, I will share how I select index funds based upon their costs.

Keep the 4 Classes' Costs Low (Low Expense Ratio)

I keep preaching to keep costs low when selecting an index fund. This is an extremely important part of the 401k investment strategy.  In fact, I mostly evaluate two things before choosing a fund to invest in.  The first is what index the fund follows.  I place most of my money in funds that follow the S&P 500.  However, the S&P 500 isn’t the only index that funds follow. The second consideration is the cost (or expense ratio) of the fund.

Index funds are known for their low costs. Nevertheless, one should not assume that all index mutual funds have a low cost.  How do you know how much a fund costs?

Most 401(k) sponsors provide access to a document center.  This will allow you to download a fund's prospectus and each fund's investment fact sheet (similar to the image below).  Both provide information regarding the fund's fees and expenses.

In particular, evaluate the expense ratio and operating expenses when comparing funds.

Even though the ratio seems minimal, the costs will add up over time.  For example, compare two funds with an assumed annual rate of return of 6%  The first, has an expense ratio of 0.04% (as shown above). The second has an expense ratio of 0.50%. What do you think the difference in costs would be on an initial investment of $30,000 with an annual additional contribution of $5,000 over 30 years?  A whopping $51,180 in cost difference!

A small percentage can add up over the years.  It is important to drive costs down so the investor can keep their hard earned money.  This will enable an investor to further increase their net worth.

In Summary

My 401k investment strategy is known as indexing.  It involves holding an index that is sponsored by a brokerage firm (e.g. Vanguard). I have invested most of my money into an index that is made up of large U.S. corporations. It is an attempt to mirror the performance of the target index, and not individual companies.

The thought is to buy and hold for the long-term.  There will be only two instances when my portfolio is adjusted.  The first, when an index sponsor rebalances the index on a pre determined schedule. The second, when I reallocate by investment percentages by a pre-determined age.  I have a plan in place for reallocating my 401(k) funds when I reach 40, 50, and 60 years old.  This will ensure I reflect on the macro gains and not short-term volatility. This is important because people do stupid things when they are emotional and/or drunk.

Finally, be sure to evaluate the expense ratios.  It is important to keep your own money, and keep the costs low.

"The greatest enemies of the equity investor are expenses and emotions." - Warren Buffett

What are your favorite index funds?  Please feel free share your 401k investment strategy.