In order to invest savings in a 401(k) a mutual fund will need to be selected. Mutual funds cover a variety of market sectors and focus their investments on particular segments. Understanding the underlying risk vs. reward on any investment choice is a key factor in making a choice.
Photo by Carolyn Forsyth
Selecting a Mutual Fund for a 401(k) or IRA
Mutual Funds perform by increasing the value of their holdings. Corporate 401(k) plans will have a variety of funds that can be selected. These funds will cover a variety of market sectors. Some are riskier than others. A fund that purchases U.S. Government Treasuries is inherently less risky than a fund that focuses on emerging markets (foreign companies). The risk/reward ratio for each of these will reflect the realities of capital markets. Today, a U.S. Treasury yields around 2% for a 10-Year time horizon. A fund focused on emerging markets should perform somewhere between a loss of 20% or a gain of 20% (this is a guess and not supported by any analysis whatsoever). It just stands to reason that with emerging markets you are exposed to currency risk (the currency could become hyperinflationary), government risk (if there is one) and market risk (shipping lanes closed, government appropriation, fraud, etc.). Note that these risks are also part of every market but you don’t expect them to occur in more established markets.
It’s likely that most individuals will select from funds in the following groupings:
Most 401(k)’s will provide a couple of funds to select within each of the Investment Focus categories. It’s not bad (nor is it necessarily good) to select a couple of funds within a category.
Risk vs. Reward
When you select a fund (even if it only invests in U.S. Treasuries) you are taking some risk and expecting some reward for that risk. Consider an investor who only invests in fixed income funds. The reward is limited to the yield on the bonds and the certainty that the capital investment will be returned. $10,000.00 invested at 2% returns $10,200.00 at the end of a year. The invested capital is safe and the return is guaranteed.
What risk was taken? The risk here is that what one could have bought for $10,000.00 a year ago, will cost only $10,200.00 or less after a year of being invested. Let’s assume we can do this investment in 2007. We have our eyes on a house in Beaumont, Texas that is for sale at $100,000.00. We intend to use these funds to make a 10% down payment. It’s now 2008. The house has not sold and has, in fact, declined in price to $90,000.00. We have our $10,200.00 and we make a 10% down payment which costs $9,000.00. We have $1,200.00 remaining which means the investment worked out because market forces altered the price of the house and our capital was retained. Moreover, we got the house at a price that was 10% less than we expected.
Now let’s do this in 2016. We again invest for a year and in 2017 we have $10,200.00. But the house we saw for $100,000.00 in 2016 has risen in price to $110,000.00. The real estate market was booming in Texas and we now need $11,000.00 for a down payment. We are $800.00 short. The real estate market moved upward faster than the return on U.S. Treasuries. Had we invested in a Real Estate Investment Trust (REIT) we MIGHT have made more money (say 10% instead of 2%) which would have given us the necessary $11,000.00 for the purchase.
This simple exercise is applicable to investing for retirement. In retirement, we all hope to have more funds than we will need and we expect to have sufficient funds to cover necessary expenses. What we can’t do is accurately predict everything that we will need in retirement will cost relatively the same as it does now. We need energy, food, shelter and health care in retirement. We also have to plan for taxes and vacations. We can’t predict what these will cost in the future but we want to be prepared to meet any changes.
When investment funds are selected, it’s important to realize that playing safe can be as risky as taking risk. There are no guarantees on the future and it’s important to invest appropriately. A meeting with a financial planner can assist with this assessment. Gathering information will help to manage your choices and setting an appropriate goal will allow you to do checks at regular intervals to insure you are on track.