Choosing Funds in Your 401(k)
When Your Options Are Few
By Austin Pryor
© Sound Mind Investing | March 2010
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!
Here are the steps for implementing Upgrading in your 401(k) using the Fund Performance Rankings:
- Using the material from your 401(k) statement or HR department, create a list of all the stock funds available to you in your 401(k) plan. You need not include money market, bond, or hybrid funds (combination of both stocks and bonds) because Upgrading is designed to help you only with the stock allocation portion of your portfolio.
- Look up each stock fund in the FPR and record its momentum score. The directory at the back will be helpful in locating the funds.
- Rank the funds according to their momentum scores.
- You will initially want to buy the top three, four, or five funds, depending on the number of stock funds you have to choose from (see table below).
- In order to build your new portfolio, you first need to dismantle your old one. So, go online, access your 401(k) account, and enter instructions to sell all your current stock-oriented holdings. Then, purchase the top-ranked stock funds you selected in Step 4 above. Invest your stock allocation money equally among the funds you've chosen.
- Repeat the ranking process each time you get a new quarterly FPR. You will want to hold each fund as long as it ranks among the leaders. The cutoff point that defines the leadership is fluid (see third column in the table); it varies depending on the number of stock funds available to you. For example, if you have 8-14 stock funds in your 401(k), you would initially buy 3 funds and hold each one as long as it maintained its leadership position, that is, ranked among the top 5.
- When any fund drops out of the leadership, sell it and invest the proceeds in the highest ranking fund you don't already own.
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 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 approach to your particular plan. Still, the limited backtesting results we've 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 very good chance of getting market-beating results.
If you're planning to employ such a strategy, you should consider using the Personal Portfolio 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. 
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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. |
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