Deciding on an allocation for your 401(k) isn’t always easy. That’s especially true if you don’t have much experience with investing. However, it’s important that you take some time to research your options and find the best allocation for you. The best allocation is the one that will help you reach your goals, but will also have a level of risk and volatility with which you are comfortable.
Here’s a quick look at few tips for determining the best 401(k) allocation plan.
Consider your time horizon.
Your time horizon is one of the most important factors to consider when choosing your 401(k) investments. Simply put, your time horizon is the amount of time you have before you will need to access the money.
If you are young and just starting your career, you have decades until you will need to access your retirement funds. That means you have a long time horizon. If you are in your 50s and retirement is approaching, you have a shorter time horizon.
Generally speaking, people with longer time horizons can often afford to take more risk than those with shorter time horizons. That’s because if you have a long time horizon, you likely have time to recover from any downturns in the market. If you only have a few years until retirement, you may not have time to recover. Think about your time horizon when selecting your allocation.
What is your risk tolerance?
Assume the market suffers a steep drop next week. What’s your reaction? Do you sell your investments to avoid further damage? Or do you stay on track, confident that the market will recover?
This question gets to the heart of something called “risk tolerance.” As the name suggests, it is your ability to tolerate risk and volatility in your portfolio. If downturns in the market will send you into a panic, it might be wise to stay away from volatile investment classes. On the other hand, if can handle the ups and downs, you may want to be a little more aggressive.
It’s important to note that there is no “right” or “wrong” level of risk tolerance. Some people are more risk averse. Others are natural risk takers. Neither is better than the other. Don’t feel that you have to select an allocation that will make you uncomfortable in the long run.
Look at target date funds.
Your 401(k) plan probably offers investment options known as target date funds. These are funds that do much of the asset allocation for you, so you don’t have to worry about picking specific investments. You simply choose the target date fund that is closest to your retirement date. For instance, if you’re 35 today, there may a fund available that is labeled “2045.” This indicates that it’s allocated for a retirement in the year 2045, nearly 30 years from today.
If you invest in that fund, the fund manager will automatically change your allocation over time to reflect your changing time horizon and risk tolerance. The allocation will gradually become more and more conservative. That cuts down on risk and volatility as you approach retirement.
Still not sure how to allocate your 401(k) funds? You may want to talk with a professional. Contact your financial advisor or the plan financial professional for a consultation on your goals, needs, and the best allocation for you.