Choosing Funds in Your 401(k) When
Your Options Are Few

SMI's successful Upgrading strategy involves picking from more than a thousand stock funds spread across five asset classes (which we refer to as risk categories). Great. But what if you'd like to Upgrade in your 401(k), and yet your plan offers only a small number of funds from which to choose? At any given time, it's not likely that you'll have a strong-performing fund available to you in each of the five categories. So what then?

We're here to offer a fallback strategy. Before getting to the explanation, however, we want to point out that this approach is not ideal. There's a trade-off involved. You're going to give up the relative stability you enjoy when you diversify across all five of the major stock-risk categories as we recommend . What you gain is the freedom to select the best performing funds available, regardless of risk category.

Depending on which funds are offered in your particular 401(k), you could conceivably end up having all your money invested in just one or two of the risk categories (in small cap growth funds, for example, or large company value funds, or perhaps foreign funds).

Concentrating your investments in just one or two kinds of categories in this way raises your risk. This means it's very important to check your fund holdings each month and follow the selling rules faithfully. If you're heavily invested in an asset class that begins to fall significantly, the system will automatically move you to funds that are doing better. But "user error" can undermine even theoretically sound systems. Your selling discipline is your life preserver. Use it!

To determine the best way to approach Upgrading with a limited number of funds, we created a hypothetical example using the stock funds at a single fund organization: Fidelity. We assumed an investor had a 401(k) account at Fidelity with access, at the outset, to 42 stock funds (the number gradually increased during the test period). The results, shown in Table A, outperformed the market in eight of the past 10 years. Here are the ground rules we used in making our buy/sell decisions:

1. All diversified stock funds offered at Fidelity were assumed to be available. We did not include any money-market, bond, or hybrid funds (combination of stocks and bonds).
2. In each Fund Performance Rankings,  we looked up the momentum scores for the stock funds on our Fidelity 401(k) list.
3. We then ranked the funds by their SMI momentum scores.
4. Initially, we bought the top four ranked funds, regardless of risk category, dividing our stock allocation equally among them.
5. We held each fund as long as it remained ranked in the top 12.
6. When any fund dropped out of the top 12, it was sold and the proceeds were invested in the highest ranking fund we didn't already own.
7. The only exception to the above was that we never owned more than two foreign funds at any given time. During the occasional periods when foreign funds dominated the rankings, this required extending the cutoff from the top 12 to the top 16 in order to have at least two U.S. funds in our mix.

The "top 12" criteria was based on the number of funds available to us as shown in Table B. We devised the table with the idea of eventually using the top 25% cutoff (as we do in regular Upgrading) as the number of available funds in a 401(k) grew.

The numbers you see in the table for six possible scenarios felt "right" as we considered how the strategy would play out in real time, but admittedly are arbitrary. You can adjust them if it seems appropriate to you to do so. (The goal is to set a high standard, but not so high that you make it difficult for the fund to maintain it, in which case you would continually be selling funds when they falter only slightly.)

Our readers participate in thousands of 401(k) plans, most of which have different lists of funds from which to choose. So, it's impossible to generalize with confidence concerning the degree of success you might expect when applying this research to your particular plan. Still, the backtesting results obtained so far are encouraging, and signify to us that, if you have at least a few strong performers among your list of options, you have a good chance of getting market-beating results.

Bear in mind, however, that a higher level of risk will accompany those results due to over-weighting in just one or two of the five stock-risk categories. As Table A shows, in some years the added concentration may be especially helpful (e.g., 2001, 2005, and 2007); other years it can hurt you (e.g., 2000 and 2008). Overall, the good likely will outweigh the bad if you can stay the course.

If you're planning to employ such a strategy, you should consider using the 401(k) Fund Tracker  available to SMI web members. You set up the Tracker by entering all the stock funds available to you. Then each month you can check those funds' updated momentum scores by simply clicking a button that generates your plan's monthly momentum-score report. This will save you significant time and inconvenience when compared with manually looking up each of your funds in the quarterly Fund Performance Rankings printed in the SMI newsletter or the monthly FPR available via our website.

By the way, checking momentum scores monthly rather than quarterly can be significant. In our testing, updating monthly rather than quarterly improved the average annual returns by about 1% per year.

Austin Pryor is the founder and publisher of the Sound Mind Investing newsletter and website. His desire is to help people understand and apply Biblically-based principles for making spending and investing decisions, ultimately helping them have more so they can give more.

• SMI Fund Upgrading page 
• Fund Performance Rankings 
• SMI 401(k) Fund Tracker 

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