Where to Invest your 401(k)

The last blog entry described the advantages of participating in a 401(k) or equivalent retirement plan. In this entry, I will focus on some investment options. Generally, a company provided retirement plan will support investing in a variety of mutual funds. The investment options will likely include money market, bonds, and equity funds.

Overview of investment types

• A money market fund is a very safe investment, similar to a savings account, and the return reflects the safety. Generally, this is really only useful in a retirement fund when retirement is imminent. The share price of a money market fund is typically one dollar although this may fluctuate. The interest, typically paid monthly, is where money is made on this investment.
  


• A bond fund invests in different types of bonds. A bond is a loan typically to a large company or government. The quality of a bond is measured in terms of the credit worthiness of the borrower. The junk bonds of 80's fame were high yield (paying a higher interest rate) and were thus more risky (the chance the principle would not be returned). A bond fund pays interest based on the interest rate of the bond. The price of a bond fund fluctuates based on the interest rates. The price fluctuates based on the return of a bond purchased currently. For example, if comparing two $100 bonds (assuming everything else about the bonds is identical) one at 8% and another at 10%. The price of the 8% bond is discounted so that the yield would be the same (2%).
  



• Equity funds invest in stocks. There are many different types of stocks large cap (which invest in large companies), small cap (which invest in small companies [relative to the large cap companies], and international funds. There are also vertical funds which invest in specific areas such as energy or technology. Stock pricing is difficult to predict because of the many variables. Earnings are growth are typically predictors of a good stock.
  

I strongly agree with the mutual fund investment philosophy of John Bogle (the founder of Vanguard). John Bogle has several books on investing but he has several premises:

• An active mutual fund, one which attempts to pick stocks which will outperform the market, is at a disadvantage to funds which represent the entire market. The rationale is that the trading and research costs will increase the expenses in the fund. An index fund can be run by a computer and does not need to spend as much on research and trading expenses. In addition to the increased expenses which put the active fund at a disadvantage, the active fund must be able to select stocks which outperform the market (the index fund). There have been several studies which show that the top performing funds for one year tend to be the worst performing funds in subsequent years. This is the reversion to the mean theory, which states that the if a fund has been earning 5% more than the average it is likely that a fund will have some losing periods to help revert to the average return. There is a great book A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing by Burton G. Malkiel which provides some great insight on stock picking and mutual fund investing.


• The other point from Bogle and many others books is on how diversification is more important than the exact fund you pick. As long as the expenses are reasonable, then the fund for the asset class doesn't matter as much. Diversification is how to allocate your investment money between different types of assets. The goal for diversification is to attempt to reduce the volatility of your portfolio with decreasing your return. Volatility of a portfolio requires going back to statistics to determine how much a typical period will deviate from the average. A smaller volatility provides additional confidence that in any given year the return on your portfolio will be close to the average. Volatility can be reduced by investing in more stable investments like bonds, but the tradeoff is that less volatile investments have a smaller return.
  

My approach has been to choose my allocation in different classes, currently I am allocated as follows:
Stocks 80% (44% in the Vanguard 500 Index Fund, 20% Mid/Small [Vanguard Tax Managed Small Cap, Vanguard Explorer Fund], 16% international (Fidelty International fund, Vanguard International Index)
Bonds 20% (Vanguard Intermediate Index Fund).