401k allocation for a 22 yr old

**jIM_Ohio** · 07-29-2010, 01:05 PM

You have learned well from the homework you've done. What you need to do is decide specifics.

Profiles might include

100% equity
80% equity-20% bonds
60% equities-40% bonds
40% equities-60% bonds

Decide which of those is the profile you want

some data (these are approximates from web sites)

over last 100-150 years

100% equity has returned about 11% with a deviation of about 19%
this means -8% happens as much as +30% and over time it averages to 11%. It will not be a smooth ride.

80% equity (80-20) has returned about 10.1% with a deviation of about 16%
this means -6% happens as much as +26%. Still averages to about 10% after 30-50 years, but don't expect to see 10% returns, expect to see 20% or -5% which when averaged, gives you 10%.

**edit to add** please notice the trend- as you add bonds volatility of returns (as measured by deviation) goes down. There are two schools of thought- one is return goes down very little by adding 20% bonds (meaning you lose .9% return but get much less deviation). The other school of thought is you add LOTS of bonds (1/5 of portfolio) and deviation hardly budges yet return went down. From my stand point if I put 1/5 of my portfolio in anything, it better have a positive effect, not a negative effect.
**end edit**

60% equity (60-40) has returned about 8% with a deviation of about 11%.
this means -7% happens about as much as +19%.

40% equity (40-60) has returned about 6.5% with a deviation of about 6. This means +.5% happens as much as +13%. 40-60 is "first" profile (as you work way down % equities) where 75% of the time all its returns are positive.

If you get statistics, what I showed above was averages within 1 standard deviation of returns. There are still years like 2008 which had -40% returns for the 80-20 profile, and that -40% was a 2.5 standard deviation move (meaning years like that are 1 of every 50-100 years). There are also years like in the 1990's where the 80-20 return was close to 50-75% (2+ standard deviations the other way).

So decide which profile you like, and set expectations based on comments like mine (I can refer you to real data if you want it).

Once you choose profile, you need to choose subclasses and domestic vs international

choices:

Large cap (domestic)
Mid Cap (domestic)
Small Cap (domestic)
Large Cap (foreign)
Small Cap (foreign)
emerging markets (foreign)
government bonds
corporate bonds
high yield bonds
foreign bonds

You can find more choices than this (not meant to be an inclusive list). Each of above could also be concentrated (holds maybe 100 securities) or diversified (holds 500-5000 securities). Many of above have growth vs value (if equities) or duration (long, short, ultra short) if its a bond.

If you choose 80% equities and 20% bonds
and choose 60% domestic and 40% foreign
then you need to do two things

each of those has a risk profile associated with it

80-20 has the return profile listed above- that represents most of the risks you will take.
The domestic-foreign has a risk profile too- the higher foreign you have, the more the US dollar and exchange rates impact return (a weak US dollar means strong foreign returns).

Again for examples sake, I will use 80-20 equity/bond and 60-40 domestic-foreign

so choose something like

30% large cap domestic
10% mid cap domestic
10% small cap domestic
10% diversified bond (find a fund which owns both government and corporate)
(that is 60% domestic and 50% equity and 10% bond))
20% large cap foreign
10% small cap foreign
10% foreign bonds (find a fund which is broad)
(that is 40% foreign and 30% equity and 10% bond)

If you split hairs and tell me you want

35% large cap domestic
15% small cap domestic
5% cash
15% government bonds
30% foreign large caps
10% foreign bonds

the return will not be much different than above. Don't split hairs over the exact choices- most of returns is coming from 80-20 (%stocks-%bonds). And some return is coming from 60% domestic and 40% foreign. Don't put all 80% equity into one asset class... if its 20% bonds its OK to put all 20% into one single bond or cash class, just make sure the choice has a high amount of holdings (choose diversified bond over long term bond or diversified bond over high yield bond for examples).

Personally I am 37 yo, I am invested close to 100% equities (its about 97-3 or 95-5 depending on the day) and I am 75% domestic and 25% foreign. I own very little foreign bonds as well.

Once you have this decided, then focus on finding a fund which matches what you chose. Do not choose a fund until you know where you are plugging it in- makes the selection MUCH easier.

**jIM_Ohio** · 07-29-2010, 01:19 PM

If I chose this

80% equity-20% bonds
60% domestic-40% foreign

30% large cap domestic
10% mid cap domestic
10% small cap domestic
10% diversified bond (find a fund which owns both government and corporate)
(that is 60% domestic and 50% equity and 10% bond))
20% large cap foreign
10% small cap foreign
10% foreign bonds (find a fund which is broad)
(that is 40% foreign and 30% equity and 10% bond)

and also had this list

Fixed Income Fund
SSgA Bond Market Index Fund
JPM Insitutional Diversified Fund
SSgA S&P 500 Index Fund
Legg Mason Investors Value I Fund
Legg Mason Appreciation I Fund
American Funds Growth Fund R5
Legg Mason Aggressive Growth I Fund
Goldman Sachs Mid Cap Value Fund
Franklin Small-Mid Cap Growth A Fund
T. Rowe Price Small Cap Value Fund
First American Small Cap Select Y Fund
Dreyfus Premier Worldwide Growth A Fund
American Funds EuroPacific Growth R5 Fund

I would possibly choose funds like this

SSgA S&P 500 Index Fund (30%- this is a large cap fund)
Goldman Sachs Mid Cap Value Fund (10%)
**T. Rowe Price Small Cap Value Fund (10%)
SSgA Bond Market Index Fund (20%)
**American Funds EuroPacific Growth R5 Fund (30%)

** means I own that fund now
I know I own T Rowe Small Cap Value- that is an excellent fund
I believe the American funds Europacific is in my wife's 401k, but I would need to check ticker to be sure.

You don't have small cap foreign available, or foreign bonds available, so read prospectus of each fund (to be sure) and then adjust accordingly

**drhughes5** · 07-30-2010, 06:13 AM

Wow, thank you for the level of detail of your reply. Pretty much everything you said makes sense at this point. I found out we also have free financial service through ING so I gave them a call to see their suggestion and try to make even more sense of all this. The profile they gave me was considered 68% more aggressive than the moderate investor. It is about 65-35 domestic/foreign with a stock/bond ratio higher than 80/20 but not 100% stock.

Here is what they suggested to me

Fixed Income Fund - 4%
S&P 500 Index Fund - 35%
American Funds Growth Fund - 26%
American Funds EuroPacific Growth Fund - 35%

The model seems to follow (at least I believe) the model you suggested; however has a more aggressive approach (considering only 4% is fixed and there is no investment in the Bond Market Index Fund). Like I said feel free to corret anything I say as I look at all this as a good learning experience.

They offer an automatic service where our accounts are reassessed every 90 days for a small fee. However, I decided to forgo that right now in hopes of motivating myself to continue trying to learn about this whole investment deal. I guess the next step is learning to track my investments and make appropriate reallocations over time. Again thanks for all your advice.

One other question I have right now. I noticed when looking at these Fund breakdowns that asset types are broken into Stocks, Bonds, Cash, and Other. I understand stocks and bonds but do not understand cash or how it plays out in the market. Thanks again for your time.

**jIM_Ohio** · 07-30-2010, 08:44 AM

Originally posted by drhughes5 View Post

Wow, thank you for the level of detail of your reply. Pretty much everything you said makes sense at this point. I found out we also have free financial service through ING so I gave them a call to see their suggestion and try to make even more sense of all this. The profile they gave me was considered 68% more aggressive than the moderate investor. It is about 65-35 domestic/foreign with a stock/bond ratio higher than 80/20 but not 100% stock.

Here is what they suggested to me

Fixed Income Fund - 4%
S&P 500 Index Fund - 35%
American Funds Growth Fund - 26%
American Funds EuroPacific Growth Fund - 35%

The model seems to follow (at least I believe) the model you suggested; however has a more aggressive approach (considering only 4% is fixed and there is no investment in the Bond Market Index Fund). Like I said feel free to corret anything I say as I look at all this as a good learning experience.

They offer an automatic service where our accounts are reassessed every 90 days for a small fee. However, I decided to forgo that right now in hopes of motivating myself to continue trying to learn about this whole investment deal. I guess the next step is learning to track my investments and make appropriate reallocations over time. Again thanks for all your advice.

One other question I have right now. I noticed when looking at these Fund breakdowns that asset types are broken into Stocks, Bonds, Cash, and Other. I understand stocks and bonds but do not understand cash or how it plays out in the market. Thanks again for your time.

Hopefully you know the difference between a small company and a large company?
For example you know the difference between Microsoft, Oracle, Starbucks and Allied Capital (or insert small company here).

I say that because as a GUESS I think these two funds
S&P 500 Index Fund - 35%
American Funds Growth Fund - 26%

are nearly identical. Might as well own 61% of one or the other.

I might be confusing growth fund with growth fund of America, so you need to check this.

Every mutual fund has a 5 letter ticker symbol- for example T Rowe Price Equity income is PRFDX and Permanent Portfolio is PRPFX. Find the 5 letter symbol from each fund chosen and read about it.

Check the top 10 holdings for each fund (any site like yahoo finance will have a section on holdings and show top 10 holdings). If the top 10 holdings are the same, find a different fund (the purpose of holding different funds is to spread your risk around, so make sure each fund you pick holds different stocks.

See if you have access to a tool like Morningstar x-ray. It costs money to use, I have free access through T Rowe Price. What xray does is list EVERY stock EVERY fund chosen holds on a table, and let you see overlap.

For example, my allocation is

45% domestic large cap (value oriented) PRFDX
15% domestic mid cap (growth oriented) RPMGX
15% domestic small cap
7% PRNHX (growth)
7% PRVSX (value- this is same value fund listed above in your 401k)
15% international large cap TRIGX
10% International small cap PRIDX

I was able to list all those without looking a single one up- I know the tickers of the funds I own... I have also owned most of those for 10-15 years.

If I x ray those, I see the following

My mid cap fund owns about 15% large cap, 50% mid cap and 35% small cap
My small cap funds own about 40% mid cap and 60% small cap
my growth funds own some value
my value funds own some growth

x ray tells me how much

The lines between small cap and mid cap can vary by the fund manager and my managed funds clearly state the manager does not have to sell if a small company grows into a large company, as long as they don't load up on large cap, I am OK, and if they do load up on large cap, better be growth, because my large cap fund is heavy into value (and any small company which grew is probably going to be growth anyway).

x-ray quantifies it for me (I run it about 1X per year to check).

You should also be aware what is a small company in the USA (worth $2 billion or less???) might be a large cap company if you put it in Africa or Asia. So even what is International large cap is not necessarily large cap when its in USA.

Another example of this is Microsoft is probably worth $250 billion (or so- just a guess) and I think we can both think of countries whose GDP is nowhere near $250 billion, so any "large" company in that country is a fraction of the size of the large companies like GE and Microsoft in the USA.

---
So my point in an indirect way is KNOW what you hold, KNOW why you hold it, and have some expectations set so you know if things are going according to plan (or not).

What was suggested looks OK, but its possible those two funds which are 61% of assets overlap considerably, but the only way to know for sure is for you to do a little homework (should take 5-10 minutes to look up top 10 holdings of each).

I know the S&P 500 fund will have Microsoft, GE, Exxon Mobil, JP Morgan Chase, Apple, P&G, Johnson and Johnson , Bank of America, ATT, IBM as top 10 holdings. If you don't know why I know that without the fund ticker, you might have some questions to ask (I have no idea of your fund ticker, but I know the top 10 holdings of that fund...)

**drhughes5** · 07-30-2010, 11:22 AM

There is some overlap between top holdings in the two funds including Microsoft, Apple, J.P Morgan, Bank of America.

The other top holdings in the growth fund include Google, Oracle, Cisco, Medtronic, Barrick Gold, and Wells Fargo

I do notice most of these names showing up a little later in the top holders list of the S&P 500. I do see what you are saying and understand that putting all the eggs into one basket is a big no no. I will keep looking into this a bit deeper. Thanks again.

**jIM_Ohio** · 07-30-2010, 11:37 AM

Originally posted by drhughes5 View Post

There is some overlap between top holdings in the two funds including Microsoft, Apple, J.P Morgan, Bank of America.

The other top holdings in the growth fund include Google, Oracle, Cisco, Medtronic, Barrick Gold, and Wells Fargo

I do notice most of these names showing up a little later in the top holders list of the S&P 500. I do see what you are saying and understand that putting all the eggs into one basket is a big no no. I will keep looking into this a bit deeper. Thanks again.

Hopefully that advice was free, you should not own two funds which overlap top 10 holdings IMO.

I can pretty much guarantee that T Rowe Small cap value will not overlap with the S&P 500 (for example). Not sure about other funds, but something to keep in mind- there was a method to some of the funds I picked (like I knew their management approach).

**TraderSmits69** · 08-02-2010, 12:44 PM

Nice portfolio, always keep an eye on the fees you pay overtime - it can crush your returns over the long haul.

**snafu** · 08-02-2010, 09:51 PM

as always jIM has done a great job! Don't get alarmed when a fund goes below your market value if it reflects market conditions. You are young enough to ride out market rollercoaster. I suggest you join no cost Morningstar newsletter to keep aware of any change to your fund's management or investment style. Many participants here like Vanguard's offering.

**ez1** · 08-05-2010, 11:08 PM

Originally posted by drhughes5 View Post

Here is what they suggested to me

Fixed Income Fund - 4%
S&P 500 Index Fund - 35%
American Funds Growth Fund - 26%
American Funds EuroPacific Growth Fund - 35%

The model seems to follow (at least I believe) the model you suggested; however has a more aggressive approach (considering only 4% is fixed and there is no investment in the Bond Market Index Fund). Like I said feel free to corret anything I say as I look at all this as a good learning experience.

Any reason they did not suggest diversification with respect to value/growth and also small/mid/large cap?

As for your 4% fixed income ... this is fairly in line with the rule of thumb that you should invest 110 minus your age as a percent in equities. In your case, that would be 88% in equities versus the 96% they suggested.

**jpg7n16** · 08-06-2010, 06:45 AM

Originally posted by drhughes5 View Post

One other question I have right now. I noticed when looking at these Fund breakdowns that asset types are broken into Stocks, Bonds, Cash, and Other. I understand stocks and bonds but do not understand cash or how it plays out in the market. Thanks again for your time.

Cash is kept by these funds for several reasons.

1st off it should be noted that it's not specifically "cash" per se, but more "cash and cash equivalents" aka money market funds, commercial paper, CDs, etc.

It keeps liquidity in the fund to serve the practical purpose of having cash on hand for new investments. Cash assets also lower the volatility of the returns (and also the returns). So while they may have bonds earning 5% with some swings in valuation (bond prices go up and down), they could offset some of that volatility with a 2-3% money market account (bank accounts don't go up and down with the market). Lower return, but lower volatility.

401k allocation for a 22 yr old