How and why to change your 401(k) asset allocation targets

When you open a 401(k), one of the most important decisions you make is how to split your money across different investments, known as your asset allocation. Over time, your financial goals, comfort with risk, and the natural movement of the markets may, and likely will change. Therefore, it's crucial to understand why and how you should periodically review and adjust the percentages you invest in stocks, bonds, and other funds within your 401(k) account to help ensure your portfolio remains aligned with your long-term retirement strategy.

Diversify your assets: an example of stock vs. bond mutual funds

You’ve likely heard the phrase “Don’t put all of your eggs in one basket”. This old saying introduces us to the fundamental principle of diversification in investing.¹ By investing in various types of financial assets, such as stock (equity) and bond (fixed income) mutual funds, you can create a more diversified portfolio, which may help to protect yourself from drastic swings in your investment value. You may be less likely to sell after a market drop.

Here’s a hypothetical example of how it might work:

Jasper had 100% of his $100,000 investments in stock/equity mutual funds. In 2008, when the market dropped 36.55%², the value of his investments fell to $63,450. Jasper, afraid of losing any more money, panicked and sold all of his stock funds. He was completely out of the stock market in 2009 when the S&P 500 returned 25.94% and in 2010 when the annual market return was 14.82%.²

Hypothetically, imagine that Jasper’s investments were better diversified and he had 70% of his assets in stock funds and 30% in bond funds. During that same year, the 10-year Treasury bond returned 20.10%.² Again, hypothetically speaking, in 2008, with a 70%-30% mix of stocks and bonds, instead of falling 36.55%, Jasper’s investment portfolio could have dropped 19.56% to $80,445. The calculations are as follows: {100,000 x ([30% x 20.10%] + [70% x -36.55%])}.³

With the smaller decline in his investments, Jasper may have been better able to stay invested during the sharp market decline and could have taken advantage of the subsequent 7-year bull market (a market in which share prices are rising).

Although past performance is not a guarantee of future results, historically, stocks' returns have outperformed those of bonds.² But stock returns are typically more volatile.⁴ By combining stock and bond funds, you can hold a more diversified mix of assets, which could help you to balance the effects of market volatility and not put “all of your eggs in one basket”. Portfolio diversification can help to smooth out ups and downs, which can help you stick with your asset allocation plan for the long term.

It is important to note that diversification does not ensure a profit or protect from loss.

An age formula to help determine your asset allocation percentages

An investor's time horizon significantly influences where they may want to direct their assets:

• Younger individuals, possessing a longer investment runway and a greater capacity to tolerate short-term market volatility, might consider selecting a higher proportion of equity funds (stocks) and a lower allocation to fixed-income funds (bonds). 

• Older investors, who have less time to recover from potential investment losses, might consider adopting a more conservative portfolio, holding proportionally fewer equities and a greater percentage of fixed-income instruments.

A simple formula often used to help investors determine a potential asset allocation is to take your age and subtract it from 120. That gives you a suggested percent of investments for the equity (stock) portion of your investment portfolio. The remaining percentage goes into fixed-income (bond) funds. 

Here’s another example:

Crystal is 36 years old. According to the above formula, Crystal might have 84% (120- 36) invested in equity funds and the remaining 16% in fixed income funds. However, this isn’t a hard and fast rule. If you tend to be more conservative and sell when you see a drop in your investment values, you may be better off placing more of your retirement and investment savings in less volatile fixed income/bond investments and a lesser percentage in equity/stock funds. Additionally, there are many online resources that could help you figure out an appropriate asset allocation for your risk tolerance and goals.

Crystal might have her investments allocated 84% in equity/stock funds and 16% in a fixed income/bond fund. This hypothetical asset allocation could be created with 3 funds, for example: 60% in a total stock market index fund, 24% in an international stock index fund, and the remaining 16% in a diversified bond fund.

Once you select your asset allocation, the next reasonable question becomes, how long do you stick with it? Below, we will explore some common ways that investors might update their asset allocation over time.

How to change your asset allocation

There are several ways you might change your asset allocation as you grow older and/or your risk tolerances, financial situation, or other relevant circumstances change. 

From our example above, at the beginning of the year, 36-year-old Crystal’s $20,000 investment account reflects her preferred asset allocation and looks like this:

Beginning of the Year Asset Allocation – $20,000 Portfolio

This example is used for illustrative purposes only and does not represent an actual investment account or strategy, and should not be construed as a recommendation to buy or sell any investment. Consult a financial professional regarding your personal situation before making any investment decisions.

By the end of the year, let’s assume that after contributing an additional $5,000, with market appreciation and the additional cash invested, her investment account could be worth $26,750. During the year, stocks outperformed bonds, and her asset allocation percentages deviated from their initial target. By the end of the year, her asset allocation could look like this:

End of the Year Asset Allocation – $26,750 Portfolio

This example is used for illustrative purposes only, and does not represent an actual investment account or strategy and should not be construed as a recommendation to buy or sell any investment. Consult a financial professional regarding your personal situation before making any investment decisions. 

The goal is to return her investment portfolio back to its original allocation. Several strategies can help get you back to your asset allocation target percentages. Additionally, there are online investment education services and tools to help automatically rebalance your investments as well.

1. Rebalancing investment strategy: Change future contributions

Whichever rebalancing approach you choose, understand that stock and bond prices fluctuate daily. Thus, even after rebalancing, your investment allocation percentages will stray from their exact allocations. We believe this isn’t a time to worry about a “perfect asset allocation”, but by knowing how rebalancing works, it can help you understand and hopefully eliminate some of the worry you have around the fluctuations you might be seeing in your portfolio.

If you’re investing each month in your workplace 401(k) plan, you can consider directing future contributions to the under-allocated fund and away from the fund that’s grown most quickly. For example, let’s assume the Total Stock Market Index fund grew to 65% of Crystal’s portfolio, 5% greater than the 60% preferred allocation. Crystal can reduce the future contributions to 56% or so to add to that portion of her investments more slowly, and start bringing her allocation percentages back to her original targets.

To lower the 19% Diversified Bond Market Fund from its current percentage allocation back to the preferred 16%, she can decrease her future contributions into this fund slightly to 13% or 14%.

Increasing the percent invested in the international stock index fund going forward to 30% or 31% helps increase the amount added to the international stock index fund, which underperformed the most during the year. This might be considered a “good enough” option, not an exact and immediate rebalancing, which is, nonetheless, an approach to be aware of.

At mid-year, or at the end of the year, Crystal can check the asset allocation to see if it’s grown closer to her preferred percentages and readjust accordingly. It is important to note that rebalancing does not ensure a profit or protect against loss. 

2. Rebalancing investment strategy: Sell and buy

Another rebalancing approach could be to sell the overvalued assets and use the proceeds to buy more of the undervalued funds. You can choose to do this once per year, and keep the new contribution percentages the same, or more often if you would like to. 

Crystal could buy and sell shares of her funds until they reached the desired asset percentage combination, putting her portfolio more in line with her allocation target percentages. As a reminder, for an account like an employer-sponsored retirement plan, it could consist of professionally managed model portfolios that are managed by a 3rd party investment adviser that rebalances the account periodically for you.   

Final thoughts about changing your 401(k) asset allocation

According to Vanguard, “the asset allocation decision—which takes into account each investor’s risk tolerance, time horizon, and financial goals—is the most important decision in the portfolio-construction process. This is because asset allocation is the major determinant of risk and return for a given portfolio.” Consequently, a flawed asset allocation could be a costly mistake in your investment account(s).

Much has been written about the benefits of portfolio asset allocation and rebalancing. Although not guaranteed, it's widely accepted that a sensible asset allocation, in line with your risk tolerance, can lead to stronger and less volatile investment returns. We believe that when and how you change your 401(k) allocation mix on a short-term basis is less important than remembering to check in on your investments each year and getting them back in line with your goals.

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Human Interest Inc. is an affordable, full-service 401(k) and 403(b) provider that seeks to make it easy for small and medium-sized businesses to assist their employees with investing for retirement. For more information, please visit humaninterest.com. Investment Advisory services are provided through Human Interest Advisors LLC (HIA) to plans that select HIA as the investment adviser. HIA is a Registered Investment Adviser and subsidiary of Human Interest Inc. For more information on our investment advisory services, please visit https://humaninterest.com/hia/.

This content has been prepared for informational purposes only, and should not be construed as tax, legal, or individualized investment advice. Neither Human Interest Inc. nor Human Interest Advisors LLC provides tax or legal advice. Consult an appropriate professional regarding your situation. The views expressed are subject to change. In the event third-party data and/or statistics are used, they have been obtained from sources believed to be reliable; however, we cannot guarantee their accuracy or completeness. Investing involves risk, including risk of loss. Past performance does not guarantee future results.