Model Portfolio Available For (Company Listing):
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Investment allocation within your 401(k) plan
Asset allocation is the most important factor in determining investment performance. Academic studies have shown that 90% of investment performance is based on asset allocation. The remaining 10% is related to stock selections and other factors. In other words, having best investments available is only the first step in securing your retirement. To grow your 401(k), you need to know how to allocate among the investments available.
We at the Invest18 are suggesting a model portfolio for your 401(k) plan, and we will update the portfolio periodically so you don't have to deal with it. But remember the model portfolio is only for your reference to construct your own portfolio. Thus, you should modify the model portfolio to fit your risk tolerance, retirement years, and financial goals. As always, you should consult a competent advisor before making any investment decisions.
FAQs
How do I invest in my 401(k) plan? An overview.
In your 401(k), you break up your total investment into 2 portions: riskless and risky.
- Riskless - the riskless portion is the investment in US government securities or even money market fund. So, if you don't want to take risk at all, then you can invest 100% of your 401(k) in the riskless US government securities fund.
- Risky - if you want to take some risks, then you should invest a portion of your 401(k) in risky investments. The different stock mutual funds combined together in a portfolio as your risky portion. Our job is to suggest an optimal portfolio allocation for your risky portion.
Based on your risk preference, you decide how much to invest in riskless and risky portion. However, the allocation within the risky portion should not be changed regardless of your risk level. In other words, the amount investing in riskless US government fund already reflects your risk tolerance level.
Example: let's say in your 401(k), you have 3 different stock funds available: A-fund, B-fund and C-fund. You can also invest in a US Treasury fund (T-fund). Based on our analysis, we suggest the optimal allocation
within your risky portion as: 40% A-fund and 60% B-fund. We drop C-fund because it is not a good fund.
Let's assume further that you have $10,000 in your 401(k). If you decided not to take risk at all, then you should invest 100% or $10,000 in T-fund. Assume you want to take some risk and invest $4,000 in riskless portion and $6,000 in risky portion.
Your allocation in risky portion:
- $2,400 (40%) A-fund
- $3,600 (60%) B-fund
- $6,000 Total Risky Portion
So, the overall allocation: $4,000 T-fund
- $2,400 A-fund
- $3,600 B-fund
- $10,000 Total
Bottom line: The only thing you need to do is to decide how much to invest in the risky portion and in the riskless portion. Once you have decided how much you want to invest in risky portion, then you can follow our suggested model portfolio for your risky portion. Or if you wish, you can modify to fit your financial objectives.
How come you only have 1 suggested model portfolio for the risky portion in each 401(k)?
The portfolio allocation for risky portion is computed based on academic modern portfolio theory (MPT). The portfolio is considered as "optimal" risky portfolio and no other portfolio can provide with higher return for the same level of risk. So, for the risk taken, the optimal risky portfolio gives you the highest return.
Why should every investor invest the suggested model portfolio for the risky portion?
The suggested model portfolio provides you the highest returns per unit of risk taken based on Sharpe ratio (highest risk-adjusted returns). In other words, the model portfolio offers you the "biggest bang for your buck". So, no matter what your risk preference is, you should invest in such portfolio for your risky portion. You should keep the allocation percentage unchanged.
Do I need to change the allocation? If so, how often do I need to change it?
In general, the model portfolio would not be changed often except for:
- Significant economic changes, such as changes in interest rates,
- Rebalancing, and
- New and changes in investments.
For your convenience, we will update our model portfolio periodically. You should check back often for any changes.
If you have any new investment or changes in investments available,
please let us know, and we can make modifications accordingly.
Why the Invest18 model portfolios are not presented based on risk category, like conservative, moderate, and aggressive?
Since the model portfolios are "optimal" providing highest risk-adjusted returns, all investors should invest in the model portfolio for your risky portion regardless of your risk tolerance level.
How can I change my 401(k) mix based on my risk tolerance level?
To reflect your risk level, instead of changing the risky portion mix, you can increase or decrease your investment amount in risky or riskless portion. If you want to take more risk, then you should invest more in the risky portion. If you are looking for maximizing returns, then you can invest 100% of your 401(k) into risky portion. Remember, you do not need to change the mix within the risky portion. If you want to take less risk, then you should invest more in riskless portion (US government securities fund).
Bottom line: you change the allocation between the riskless and risky portion to reflect your risk level.
How do we construct the model portfolio for the risky portion?
We construct the model portfolios based on academic modern portfolio theory (MPT). Here's how it works:
- For each investment available in the 401(k), we first calculate historical returns and volatility (risk).
- We find the correlations among the different investments.
- Based on our own selection criteria, we decide which investments should be considered for the risky portion.
- Then, we use different allocation percentage to find all possible portfolios given some conditions, like each selected investment should have a minimum 5% invested to ensure diversification.
- For all possible portfolios, we calculate hypothetical returns and volatilities (risks).
- Finally, we find the optimal portfolio, which give you the highest return for each unit of risk. In other words, the model portfolios give you the maximum returns for each unit of risk you are taking, i.e., highest risk-adjusted returns.
Therefore, all the model portfolios are constructed based on quantitative methods using historical information. As we all know, past results are not the best indicators for future performance. However, unless you know what the future would be, historical data is the best information we currently have.
What is Modern Portfolio Theory (MPT)?
Different investment returns are impacted by differing market factors such as commodities and interest rates. Each investment (mutual fund) has its own unique risk. However, when you put all these individual investments into one portfolio, the overall portfolio risk is reduced. The reason is that the unique risk associated to an individual investment can be offset by another different investment type. This concept is commonly known as Modern Portfolio Theory ("MPT") and was proven by Nobel Prize-winning economists Drs. Harry Markowitz, and William Sharpe who studied the effects of diversification on a portfolio's overall risk level.
How do we determine what funds to be included?
First thing we do is to review the funds available in your 401(k). Then, we will determine which funds should be considered based on their past performance, expenses, and any related fees, and the correlations. In other words, we "screen" the funds to determine which funds are to be considered in our model portfolio construction.
Why not all funds are in the model portfolios?
Some companies have offered a lot of investment choices for their employees. If you invested in all the funds available, you would be over-diversified, which is actually not a good thing. When you over diversified, your total return may not increased. The benefit of diversification (reduced overall portfolio risk) can only be effective up to a point. Diversification can only eliminating the unnecessary non-market risk (nonsystematic risk). Diversification cannot reduce market risk (systematic risk). Thus, no matter how many stocks or funds you hold, the market risk will always be there. Over-diversification may even reduce your total return while cannot reduce the portfolio total risk.
We specifically exclude:
- Asset allocation or Life-cycle funds - some 401(k) include "asset allocation fund" or "life-cycle fund". These funds are themselves investing in different asset classes. So, you can actually invest in these funds so you do not need to do the allocation yourself. Thus, we exclude these funds in our calculation.
- Money Market funds - Money market is short-term interest earning funds and may be considered as riskless investments. They can be used for money waiting for investing or for emergency reserves money. But these funds are not good for long-term investment. Accordingly, we do not consider them. However, you can invest in them for your riskless portion.
- "Private" funds - some 401(k) offer funds that are not publicly available. In other words, you cannot buy these private funds in the market. Therefore, no public data is available for our calculation. Accordingly, we have no choice but to exclude these funds also.
- "New" funds - some companies offer newly launched funds in their plans. Although these funds have data available, they do not have sufficient history. Since our model portfolios are based on historical data, we generally like to have about 5 years history to get some meaningful analysis.
- Sector Funds - we specifically exclude sector funds due to their inherited high risk level. However, sector funds can satisfy investors who are looking for aggressive investment opportunities. Therefore, these investors should adjust our model portfolio to reflect their specific risk appetites and investment objectives.
