Five Questions for the Finance Guy
As heard on MomsMakingaMillion radio with Gina Robison-Billups and Kathleen Bellucci
“So you’re looking at your 401(k) and suppose its just average. Not too large and not too small. Can you pick too many funds?”
Five would be about the optimum number to own. Because you have to begin somewhere, most of us opt for the index fund that tracks the 500 largest companies. This is good first choice and if the 401(k) is really small, a decent only choice.
“How do pick which fund is best?”
Some of us will take the default fund – which is the target date funds we spoke about last week. But to get a truly diverse 401(k), one that offers us some protection in times of lower returns, we need more than one fund.
Two things need to be considered. First, keep in mind that mutual funds, whether they are index funds or actively managed funds, invest in stocks or bonds or some combination. Some invest more heavily in some stocks and less in others. This is called weighting by the pros. Too much weight in one area is not good.
Once you begin looking to add funds to your portfolio beyond that S&P 500 index or large-cap index, try to avoid owning a fund that has too much of the same kinds of stock.
With index funds this is relatively easy to do. Simply pick another index that focuses on a different part of the market, such as an index that invests in the small-cap area and mimics the Russell 2000.
Most 401(k)s have these kinds of funds. Building a decent portfolio with index funds can be a good choice for most investors.
The problem begins when we invest in actively managed funds. These funds tend to suffer from style drift.
“Style drift. What’s that?”
In an actively managed mutual fund, the manager is looking for a good return and may buy stocks that are not necessarily what the fund claims it owns. An example would be when a large cap fund manager buys mid-cap or small-cap stocks to boost returns.
“So returns may not be what they seem?”
Short-term returns should always be disregarded. Look for funds that have a long-term track record that is consistent. This means the fund manager has navigated the fund through good times and bad and has beaten similar funds and any index they might compare their performance against. Use five years minimum; ten is better still.
What would a good 401(k) portfolio look like?
Depending on the size of your plan, five funds. Index funds primarily that invest in the following five categories are found in most 401(k)s, even the ones that aren’t so great: large-cap, small-cap, mid-cap, international and bonds. You can divide the contribution up evenly and net some very good long-term results. They will all perform differently – and that’s the idea – so don�t be swayed by the differences in returns. Once you do that, all you need to do to be successful is to increase your contributions over time as you earn more. Start out with 5% and keep moving it up with each pay raise.
Have a question of your own? Write me!
Paul Petillo is the Managing Editor of BlueCollarDollar.com
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