This video discusses the three categories of investment options available to 401k investors based on their level of investment experience.
The Best Investment Options in Your 401k
So what are your options when comes to selecting investments in your 401k plan? In this video we’ll be discussing the types of investment options found within most 401k plans.
First of all, not all investors are alike.
That’s why the typical investment menu in a 401k plan offers three categories of investment choices; each one geared toward a different level of investment experience and desire for investment control.
These three categories include:
1) Pre-mixed asset allocation funds
2) Individual mutual funds (what I call Building Block funds)
3) Brokerage Account Option (also called a “brokerage window”)
Pre-mixed asset allocation funds are designed for beginner investors who don’t want to build their own asset allocation, but prefer an investment option that’s managed for them. This would be similar to buying a pre-made cake in the box.
There are two types of pre-mixed asset allocation funds:
1) Risk-Based Funds
2) Target-Date Funds
Both types are “asset allocation” funds that mix multiple asset classes together in one fund which typically includes stocks, bonds and cash.
They come in two flavors:
“Risk-based” asset allocation funds (sometimes referred to as “Lifestyle Funds”) are packaged based on an investor’s risk tolerance. What makes them different from one another is the ratio of stocks to bonds. For example, a Conservative allocation, which is designed for conservative investors, may have only 30% stocks and 70% allocated to bonds. While a Moderate risk investor may find 60% stock in their fund’s allocation and an Aggressive allocation designed for investors with a higher risk tolerance may hold 90% stocks.
This leads us to the next type of asset allocation fund which is called a Target Date fund. What makes these funds different from Risk-based funds is that the fund’s allocation to stocks gradually declines a little each year the closer you get to your “target” retirement date. So rather than selecting a fund based on your risk tolerance you simply select the fund that’s closest to your retirement date. People expected to retire in 20 years will have more stock exposure compared to someone planning to retire sooner.
These are the simplest of all investment options because they allow investors to “set it and forget it”.
The second category of investment options are individual mutual funds, that I call “building block funds”. These are funds that invest in a single asset class, such as US large companies. A typical investment menu may offer several different asset class funds such as: US Large companies, US Small companies, international stocks, and bond funds. These funds allow investors to build their own asset allocation from a list of funds whereby they choose how much they want to allocate to each fund. This option is geared toward an investor with some investment experience who wants more control in managing their own portfolio.
This is like being given a package of ingredients but you make your own cake.
And lastly, the third option, which may be available in your plan, is called a self-directed brokerage account also known as a “brokerage window”. This option allows you to buy investments that are “outside” of the limited number of funds available in your plan’s investment menu. This option is designed for investors with the most investment experience who want to build their own portfolio by accessing low-cost exchange-traded funds, mutual funds, stocks and bonds.
If pre-mixed asset allocation funds are similar to buying a pre-made cake in a box; and building block funds are similar to being given a package of ingredients; the brokerage account option would be similar to having access to the grocery store, allowing you to buy your own ingredients that you feel are the highest quality and the lowest cost.
So what are the potential drawbacks and benefits to investors when comparing these three investment options?
The potential drawback for Risk-based funds is that you can’t control your asset allocation; while the drawback to Target Date funds is that they assume that all investors who select the same retirement date have the same risk tolerance. Because of this, a young investor who is conservative is forced to have a high exposure to stocks because their retirement date is further away, and an older investor who is aggressive is forced to have a lower allocation to stocks because their retirement date is sooner.
The potential drawback to building block funds is that your fund options are limited and therefore you may be missing asset classes that can deliver diversification benefits. Also, your fund expenses may be higher than similar funds in the same fund category.
What about the brokerage account option? If you’re going to use this option you will be subject to transaction cost whenever you buy or sell an investment, which is why this option may not be suitable for small accounts.
So, what’s benefit of each of these options?
For Pre-mixed Asset Allocation Funds – the answer is simplicity.
For Building Block Funds – it’s the ability to build your own asset allocation.
For the Brokerage Account Option – it’s the ability to have more control, allowing for greater diversification and the option to buy funds with the lowest expenses, such as low-cost ETFs.
So, for those of you looking for the most convenience, premixed asset allocation funds are your best bet. Whereas, if you’re the type of investor who wants to have your cake and eat it too, the Brokerage Option gives you the most control and greatest number of investment options.
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