As a financial professional and an active personal investor, I often get the question: so what should I do with my 401(k)? I think most finance workers and even financial advisors hate this question because the quick answer is: I don’t know.

There may be a number of reasons we, we being your friends or acquaintances who work in the financial industry, don’t know but I will break them down to 2 simple ones:

1. We Just Don’t Know– Finance is a vast industry, encompassing everything from paper pushers and cashiers to quantitative portfolio managers with PhD’s and here is a little dirty secret: a lot of them don’t know how to manage their own personal finances. I have seen sophisticated financial professionals with decades of experience make the most boneheaded moves when it comes to their personal investments and even met many that seemingly have no savings at all. Not only do these types not know, but they may be the definition of who you should not ask for financial advice. Most of us don’t just scream buy and sell orders into a phone all day. We have a niche skill set that is a single view of one side of a vast market. It could be securitization, loan capital markets, risk, compliance, operations or trading. So don’t assume we all know.
2. We May Know – But we have no idea what you have in your portfolio. If your entire portfolio is Tesla, I wouldn’t advise you to start dollar cost averaging new contributions into an index fund, I would probably slap you upside the head and tell you to get the hell out of it and take your gains. Part of the role of an advisor is to know a client’s risk tolerance and goals and help them to construct a portfolio with these things in mind, without having this broader picture, we can’t just tell someone to buy Apple.

With that being said, since I write this blog on a regular basis, have a view of the broader macro economy and take my own personal investing very seriously, I will likely have an opinion on what I think someone should do with their money, provided I have the information I need to make an opinion.

Starting Out

So if you are starting out, the target date fund is probably the best and easiest option to start with. After an Obama era law mandated that retirement plan providers make target date funds the default investment, money poured into these funds from retirement plans across America. Previously, and unbelievably, many people just dumped cash into their retirement portfolios which was a massive giveaway to the retirement providers who could simply on-lend those funds. Anyway, the logic to have target date funds as the default fund is very simple: a target date fund provides a diversified mix of stocks and bonds which gradually tilt more conservative as you approach retirement age. What this means is that a typical target date fund will have 80% to 90% equity when a worker is younger and 10% to 20% in bonds. At a predetermined age, say 40, the fund starts to slowly allocate more and more towards bonds and away from equity until at retirement age you may have anywhere from a 50/50 mix to a 60/40 mix of stocks and bonds. This is called the “glide path” here is the asset mix over time as visualized by Vanguard.

I am a bit critical of this simplistic view as many government bonds are just not a great long term investment at the moment but we will get into that in a bit. I have another beef with target date funds as they leave something to be desired when it comes to diversification and market exposure.

Diversification

There has been overwhelming research that supports that over the long term, meaning greater than a 15 year time horizon, very few active managers beat the market. This has helped spur the move towards index funds, or funds that simply track the composition and returns of an index like the popular S&P 500. The next question however is what index do you track? There are literally thousands of indexes, some are well known and others are not, how do you know which is best?

Indexes overall tend to offer diversification. Diversification is another strategy for the long term for risk reduction and investing in a well known index like the S&P 500 will give you some diversification as it consists of the largest 500 companies weighted by market capitalization in the stock market. This is also called the market cap, or the value of all of the equity of a company. The Dow on the other hand, only consists of 30 stocks so is not as wide of an indicator of market performance. Other indexes attempt to track all the stocks on the New York Stock Exchange (NYSE) like the Wilshire 5000 index.

One fund that has become quite popular to track the entire stock market, which acts similar to the performance of the Wilshire 5000 is the Vanguard Total Market Index VTSAX or its ETF equivalent VTI (I like ETF’s because they are slightly cheaper due to their structure).

In the industry jargon, the S&P 500 is known as a large cap index and the total market index is known as a large cap blend. That means it also includes some small cap names but these only make up a small portion of the index.

There are some important differences between these indexes you should know about though and will help you understand why the target date fund may not be enough. The S&P 500 being market cap weighted will hold more of the largest market cap stocks, in other words, the largest public companies. These will be names like Apple and Microsoft. Currently, the top ten stocks in the S&P 500 make up about 28% of the index. For VTSAX, they make up around 23%. This means that both indexes will be what I like to call “top heavy” or weighted towards the big names, this means that the performance of the big companies will also dominate the performance of the index. This becomes even more important now that a wildly overvalued name like Tesla is in the top 10 of the S&P 500. Were valuations to become more reasonable for that stock, it could drag down performance of the index overall.

For these reasons, it’s important to diversify away from just the large cap indexes because they will leave investors exposed more to the large cap names. Other indexes like those that cover large cap growth, large cap value, small cap growth and small cap value have a place in your entire portfolio because they capture different portions of the market.

The case for diversification of index strategies as well as market caps is clear. In different types of market environments, different indexes will perform well. Right now we are in a large cap growth cycle. Small cap growth has also done well. These indexes are currently weighted more towards technology companies which have done well lately. Value indexes have been much maligned in the past few years but these indexes tend to perform well when one segment of the market is overvalued, like the growth sector or is in bear market territory. In a recent post, I highlighted how the Russel 3000 value index climbed by 80% from 2000-2003 while the S&P 500 fell about 40% in that same period.

International exposure is also important as it hedges against underperformance in the US as well as a weaker dollar. Again, in recent years this has been a weaker strategy, the US markets, led by tech companies, have had breakneck growth in their share prices and left those in Europe, Asia and Emerging Markets in the dust. However, it’s important to keep in mind that we can’t expect that outperformance to last decades, which if you are under 55, is your horizon for your 401(k). There are even indexes that track all the stocks in the entire world. The FTSE All World Index attempts to track all the listed stocks in the world, again weighted by market cap. This index consists of about 55% US stocks and 45% non-US stocks.

From the period 1928 to 2018, the S&P 500 as well as the Total Market Index returned 9.7% and 9.5% annually. However during that same period, small cap value returned 13.1%. Small cap value will not outperform over shorter periods but long term there are super cycles where strategies go in and out of favor, which is why it’s so important to diversify between them. One study showed that even diversifying 10% towards small cap value from large cap investing for a 40 year old could yield as much as 25% more in retirement.

What This Means for Target Date Funds

Target date funds are overwhelmingly allocated towards the large cap indexes and the total market indexes which, as we have seen are also weighted towards large caps. Small caps and value indexes are important diversification tools that can not only make your returns over the long term less volatile but also potentially offer greater returns.

My favorite low cost investing provider Vanguard offers a number of US and International based funds which track both small cap, large cap, growth and value indexes. These funds include names like VUG, VTV, VBK, VTV and VWILX. These are Vanguard funds but usually large fund companies such as T Rowe Price and Fidelity have similar offerings in these spaces.

To give a personal testimonial, I previously had a Roth IRA invested in a Fidelity fund which tracked the total market index. Using this logic I diversified away from my core target date fund and put some of this account into a small cap and an international growth fund. Since that time I have seen a 78% growth in these two funds combined versus a 32% growth in the target date funds. This happened to be good timing but is an example of how a simple move to augment a core investment in target date funds can offer better returns. Giving this often overlooked diversification strategy could make all the difference if you are already investing in a target date fund for retirement.

Target date funds are a useful tool for automated “set it and forget it” investing but they aren’t always comprehensive. Diversification to value, growth and small cap funds can potentially add more to your return without sacrificing your core investment.

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