Simple Tip to Assess 401 K Risk
Let's face it, investing in normal times is often confusing and challenging. Amid potential war between Russia and the Ukraine, inflation, and the threat of rising interest rates, investing can be a daunting process. The key is to understand how much risk you are taking in your 401K plans. Most importantly, you are OK with that risk.
There are many different ways to analyze risk, none of which are without difficulty. However, there is one way to assess how much risk you are taking and use that information to make decisions. If you have been following my writing, you know I'm not a big fan of oversimplifying investing and dealing with money.
There is a certain amount of difficulty with the process, and nothing is guaranteed. I will leave simplicity to the pop culture finance crowd.
The process I'm referring to is not perfect and is not, by all means, a solution. However, it is a way to assess risk and can be very useful when working with a financial advisor or making investment selections on your own with your 401K plan. I use the same process with my clients and their investments in company 401 K plans that I can't physically manage.
First, let's look at the assumptions that we will be making.
There are only two types of investments in most 401K plans. There are stock investments, and there are bond investments. Although bond investments can lose money, they are considered the most conservative part of your 401K portfolio. Bond investments are especially vulnerable to rising interest rates. Remember the formula - if interest rates go up, bond prices go down, and if interest rates go down, bond prices go up.
Also, we are working with stock and bond mutual funds.
Second, let's divide your 401K account between the amount of money you have invested in stock-based investments and the amount of money you have in bond-based investments.
If you have 40% of your money in bond-based investments, you should have 60% of your money in stock-based assets. There are a lot of combinations percentage-wise.
Finally, you are ready to assess risk.
Identify the percentage that you have invested in stocks. For example, let's assume that you have 50% invested in stocks and 50% invested in bonds. That means you are taking 50% of the risk of the stock market. Let's say that you have 70% in stocks and 30% in bonds. That means you are at a 70% risk level.
How to reduce risk
Think of it as driving a car. If you want to go faster, you put your foot down on the accelerator and give the cars some gas. If you're going to slow the vehicle down, you put your foot on the brake and apply it. The same goes with your 401K investments. If you want to increase the risk, you give the account some gas by raising the money going into stocks. If you want to decrease the risk, you apply the brake by increasing the amount of money going into bonds and reducing the amount going into stock.
Let's say that you have 70% in stocks and you want to decrease the risk level. Then you have to decide at what percentage of risk are you comfortable. Could it be that you are comfortable with 30% in stocks meaning that you are taking 30% of the risk of the stock market? In that case, you would move the rest of the money into bonds to equal 70% on bonds. Once again think of it as driving a car. If you want the car to go faster you give it gas and if you want the car to go slower you apply the brakes.
A couple of disclaimers - First, bonds can and will lose money. They are not a safety net 100% of the time. However, they are the more conservative position in a 401K portfolio. There is always a low probability that bonds could lose money more than stocks at any given time. Also, bond funds are not created equally. Some bond funds can be riskier than others. Finally, a money market account, although not a bond fund, could also fit in this bond category
Finally, this is one way to assess risk. I am not trying to suggest it is full proof in any way. If you ever have any questions feel free to email me at email@example.com.
Bob Brooks is a financial advisor in radio host of the pretty money radio show. His primary responsibility is working with clients in helping them get from point A to point B, managing risk
along the way. If you want more information about Bob, email us at firstname.lastname@example.org.