Excellent Advice on 401(k) Investing

“Modern Portfolio Theory offers one of the strongest tools available to the rational investor.” – Frank Armstrong

It’s a nice change of pace to have something positive to say about an investing article from the mainstream media. Believe me when I say that finding and commenting on misleading articles can be exhausting.

Well, Forbes’ recent article on Portfolio Calculus For Your 401(k) is nothing short of a breath of fresh air. It is a well-written article which offers a succinct explanation of Modern Portfolio Theory and its practical application to investing in a 401(k) plan.

There is no hype, no promises to “beat the market.” Just good sensible advice. AAII Staff is credited as the article’s writer; AAII being an acronym for the American Association of Individual Investors, a non-profit organization that educates its members about investing and financial planning issues.

The article recommends four very sensible steps to creating a well-balanced 401(k) portfolio.

1. Determine Your Risk/Return Preference
2. Form a Diversified Portfolio
3. Select Mutual Funds
4. Rebalance Periodically

I could not agree more with the process outlined; the first three steps are quite intuitive, and need no further explanation beyond that in the article. Not so with the last step.

Rebalancing

As the article explains, from time to time, you need to “readjust” your portfolio to restore its original balance. Because of market forces, the relative values of the components of your investments change over time. That’s the reason why you diversified your portfolio in the first place (or at least, why you should).

The rebalancing solution may be difficult for many investors for two reasons. First because you may have to sell off some of your “winners” and buy more “losers.” From a psychological standpoint, this may be an unusual and counterintuitive decision for many investors. But merely by virtue of market dynamics, “winners” cannot always be “winners” and “losers” will not always be “losers.” Second, if you have more than one investment account, you will have to decide which one to rebalance and when to do it. This can depend on the options available in your retirement account, cost of transactions, tax considerations, restrictions, etc.

It may not be easy, but periodic rebalancing of your portfolio is essential if you want to prevent it from getting “out of whack.”

Your Entire Portfolio

While the singular aim of the article was to explain what to do with a 401(k) allocation, similar considerations can and should apply to all of your investments. In fact, I believe that you should set up  your entire portfolio at the same time that you are making decisions about your 401(k).

Asset Location

When setting up a portfolio, one factor not sufficiently mentioned, though, is asset location — how you distribute your investments across taxable and tax-deferred accounts, e.g., 401(k) or IRAs.

The goal is to divide your investments in a way that will defer taxes and ultimately provide the best after-tax returns.

Under current U.S. tax law, long-term capital gains and “qualified” dividends are taxed at 15 percent for most taxpayers, and most other investment income (nonqualified dividends, interest and short-term gains) is taxed at marginal rates of up to 38 percent.

Not only are different kinds of income taxed at different rates, but income from tax-deferred accounts isn’t taxed in the year it is earned – instead, all contributions and earnings are taxed when the money is taken out.

While this seems complicated, we can simplify to some extent. In general I recommend that you hold tax-efficient assets like stock index mutual funds in taxable accounts. Tax-inefficient holdings, such as fixed income funds and Real Estate Investment Trusts should be held in tax-deferred accounts, whether it is a 401(k) plan or an IRA.

Conclusion

For any investor, this Forbes article is more than worthy of earning a place among your browser’s bookmarks. Bear in mind, though, that for some investors actual implementation of rebalancing and asset location may pose a challenge.