What can you do with your 401(k) plan? A prior article has already discussed the advantages of continuing your contributions and taking advantage of the concept of “dollar cost averaging.” (“What Should I Do with My 401K?” October 11, 2008.) This article will consider the investments already in your plan. How can you be proactive with your 401(k) plan and still follow the current recommendations:

•    Always have a strategy that results in buying low and selling high
•    As long as time permits, sit tight on your plan so that you can experience the market recovery

First and foremost, continue making contributions. The tax advantages and any employer match allow you to acquire more low cost shares that can accelerate your plan’s recovery. The next step requires work on your part; after all, you wanted to be proactive. This proactive adjustment to your plan requires five steps.

1. Look at each asset class of investments allowed in your plan, and determine the dollar value you have in each class.

Hopefully, you have some diversification in your plan, perhaps having followed an asset allocation model based on your risk tolerances. Even if you have all your eggs in one basket and only have one investment, these steps may still be applied. Asset classes are nothing more than a grouping of investments with similar risks and expected returns. Some examples are fixed income, large company equities, small-cap or mid-cap equities, balanced funds, and international equities.

2. For each asset class in which you have some money, research all available investment choices in that class.

• Use all information provided by your plan
• Use on-line information available from mutual funds, Morningstar or other fund evaluation sources
• Compare the performances for the past 1 month, 3 months, 1 year, and 3 years as well as internal fees and expenses

3. Of the available choices in each asset class, decide which fund you would rank number 1 and number 2. Also, determine which fund you determine to be the most volatile – biggest swings over the same periods.

4. Using just the dollars already in an asset class, reallocate half of that amount to the fund you ranked number 1 in that class.

• If you are within 10 years of retirement, put the other half in the fund you ranked number 2 in that asset class.
• If you are 10 or more years from retirement, then put the other half in the fund you determined to be the most volatile in that asset class.

(Note: even though we may be changing investments, we are just shifting to a similar investment that probably has a better chance of recovering faster. We are not being stupid by selling low and buying high – we’re selling low and buying low.)

5. Determine the percentage of your investment in each fund, and reallocate to this percentage at least every three months.

• Be sure to check your plan’s rules for reallocating as sometimes fees may be charged. You want to be sure that the fees do not offset the gains in reallocating.
• Reallocating is nothing more than taking gains from the better performing funds whose prices are up, and shifting it to lesser performing funds whose prices are low. (A fancy process for continually buying low and selling high.)

What do these five steps accomplish? You have stayed within our rules: your strategy assures that you buy low and sell high, and that you give your investment the best chance possible of recovering. Although this may seem like a lot of work for just a little change, it is a strategy that combines almost all of the current financial advice in a proactive manner. You have the satisfaction of doing something about your retirement plan, and the confidence that you are not doing something stupid.

PlanLab News provides no investment advice nor does it offer any opinion with respect to the suitability of any transaction. Clients should consult their legal, tax, and/or financial advisor before taking actions based on this information.

The answers must consider individual situations, but a few basic concepts should always be considered before making decisions to each question.

Should I take my money out of my 401K Plan?

If you take your money out of your plan, it is subject to income taxes. Paying taxes on the decreased values will increase your losses. If you are under 59 ½ you may pay an additional 10% penalty tax. You can avoid the taxation by rolling over to an IRA, but that generally provides no advantage to leaving it in the 401K. Unless the money is immediately needed for another reason, you should not take it out of the plan.

Should I change investments in my 401K?

If you are close to retirement, say within five years, you definitely want to reexamine your asset allocation to be sure you are not too heavily invested in stocks. If you are already retired, you want to be sure that the portion, from which you are taking your retirement income, is in very conservative investments. In most cases, if your investments are diversified, you should consider leaving them as they are. If you move them to a low risk investment now, they will not be able to recover. The more time you have between now and retirement, the longer you can wait for the values to recover.

Should I continue to make contributions to my 401K?

Yes. First, you always want to take advantage of any employer match—it is free money. For example, if the employer matches $.50 for each dollar you contribute, that’s like earning 50% after taxes for each matched dollar. Regardless of economic conditions, you should always contribute up to the amount that the employer will match.

The other reason that you want to contribute is called dollar-cost-averaging. This principle always works to your advantage, but it is especially advantageous when the market is down— like it is now! Here’s how dollar-cost-averaging works. My making monthly contributions, you purchase shares based on their value each month. If the price per share goes up, you get a few less shares that month. If the price goes down, you get a few more shares. Proportionately, you get more additional shares when the price goes down than you give up when the price goes up. Consider the example in the chart below.

$100 is contributed each month. The first month the price per share is $5, so 20 shares are purchased. The price goes up the next month to $6 per share. The $100 buys 16.667 shares. The third month, the price is back to $5 and 20 shares are purchased. The next month the price drops to $4 per share, so you receive 25 shares. If the price returns to $5 the next month, 20 more shares are purchased. You now have a total of 101.667 shares worth $5 per share for a total of $508.33. It is easy to see that the average price paid per share was $5. Had all $500 invested been invested at the average price, you would only have had 100 shares worth $500. Systematic purchasing with varying prices allows you to do better than the average.

Let’s continue the prior example, but this time let the prices go really low. This time, the price continues to decline to $1 per share. It would be easy to get discouraged when the price has fallen so low and values so low, but continuing to contribute each month until the market has reversed, provides substantial gains. In this example, dollar-cost-averaging has produced 30% more value than would have been earned buying the stock each month at the average price.

If we had lost our nerve when the price reached $1 and quit making monthly purchases, we would have only had $1,325 when the market had recovered.

For someone who is a number of years from retirement and has time to let the market recover, dollar-cost-averaging can make this economic crisis a “blessing in disguise.”

Photo credit: m kasahara