I always hate it when I look at the returns in my 401K because, while they may be really good some periods, they aren’t as good as they could have been. I have my 401k funds invested about as follows:
15% Large Cap Index Fund
20% International Index Fund
15% Large Cap Value Fund
15% Mid Cap Index Fund
10% Small Cap Index Fund
10% REIT Fund
7% Developing Markets Fund
8% Convertibles Fund
Note that I currently don’t hold any bonds, since I think interest rates have nowhere to go but up, making bonds risky. Instead I have the REIT fund and the convertibles fund that provide investments somewhat uncorrelated to the equity investments and which also provide some income to soften the blow during down markets and provide return when the markets are stagnant.
Lately the small caps and mid caps have trouncing the large caps. I therefore have 25% of my portfolio going up 35-45% per year, while the rest is only going up by 15-25% per year. Looking at this, I can’t help but wish the large caps were doing as well as the small caps, or that I had a lot more in small caps. International also did badly earlier in the year, although it has recovered somewhat lately.
These feeling of wanting to chase returns are natural, but miss the whole point of diversification. It is true that I am not doing as well as I would have been if I had put 100% into the small caps fund. Still, I am doing better than I would have been if I had invested it all into large caps, a bond fund, or the international fund. Because I have some money in small caps, I do better than I would have if I didn’t hold any small caps. Likewise, if large caps do well over the next year as analysts expect them to do, this becoming an old bull market where large caps tend to outperform small caps, I’ll do better than I would if I were entirely in small caps.
In fact, small caps have done so well that many analysts think they may be due for a correction or at least a breather while they wait for earnings to catch up to their lofty prices. It that is the case, I’ll be happy to be partially in large caps instead of being fully in small caps, thinking that the rally will continue for another year.
Because I don’t know which segment of the market will do better this next year, I want to have some money everywhere. That way no matter which segment is having a good year, I’ll be making money. If I have two investments, one that makes 12% and the other that makes 20%, if I hold equal amounts of each I’ll make 16%. This isn’t as good as I could have done if I had invested it all in the second investment, but still it is a lot better than I would have done if I had been wrong and invested it all in the first investment.
So when investing in a 401K account, or investing a large amount of money in general, sometimes you need to settle for good enough. The truth is the analysts don’t know what will do the best during any period of time and neither do you. You always want to have some money in the winning area, even if it means you don’t have all of your money there.
Does this mean you should always have bonds and fixed income investments as well? No. While bonds may be the big winners over stocks in some years, over long periods of time bonds don’t perform as well as stocks, and therefore you’ll be giving up a significant amount of income if you are 50% in bonds, say, from the time you are 20 until the time you are ready to retire. Bonds are for the time when you are nearing retirement and need to worry about wealth preservation more than growth. Before that, most of your money should be in stocks.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
