What’s in your 401(k): Effective Passive Investing

Many of us have a pretax investment account – likely one of the 401(k) varieties. This is a great move as it utilizes pretax dollars. Money deducted from a paycheck automates investing meaning we invest regularly. Also a plus.

When asking about what investments, I hear answers such as, “I’m investing in my 401(k).” This is great, but satisfies a portion of the question as the 401(k) refers to the account type, not actually the investments.

What are your investments within the 401(k) account? Many don’t have an answer. They just don’t know. They may have chosen a plan when starting the account. But many don’t know what their money is actually buying.

To best help readers understand their investments, I’m going to dial the investing lingo way back on this one. At a basic level, a retirement account is likely a mix of stocks and bonds.

What is a stock?

When a company needs to raise money, they sell thousands or millions of teeny tiny portions of their company. One of these small portions of equity is known as a stock or share. You become a stockholder when you trade your CRNA dollars for a piece of (digital) paper saying you own small portion of a company – say 1/ 100,000,000th.

Money is made when a company becomes more valuable (capital appreciation) or offers dividends (distribution of profits). If you paid $100 for a stock in a solid company, that stock may be worth $110 in one year. This is an unrealized gain of $10 per share. It would become a realized gain if you were to sell the share.

That stock may also pay shareholders a dividend such as a dollar each quarter as a way to keep investors happy. Kind of like interest on your investment.

It’s unlikely that your 401(k) manager invests in individual stocks because the volatility is far too high for a long-term account.

A single tweet from Elon sends Tesla stock shooting in one direction or another. Similarly, bad publicity or a scandal can drastically alter a stock price overnight.

Plus, few companies remain relevant for 50+ years. Look at the giants Yahoo and Sears. Purchased by the competition and remembered as a past time. Sure, Google and Amazon are big now, but give it another 20 years.

I tangent by saying there are interesting documentaries about how massive companies slowly lose the successful businesspeople responsible for their exponential growth. There are only so many top spots in a corporation. Motivated businesspeople who were not fortunate enough to receive one of those seats transition to other endeavors or take a higher position at a smaller, younger company.

So, what is my 401(k) invested in?

A major portion of a 401(k) is typically invested in index funds or mutual funds. What are those you ask? Both are baskets of stocks. By having a variety of stocks, volatility of any single stock only minimally impacts the value of your 401(k).

Indexes

A market index is a representation of a segment of the market. Indexes may include only the 30 largest U.S. companies by value – the Dow Jones. Another index includes the 500 largest U.S. companies – the Standard and Poor’s 500.

When you hear people saying the market is up or down, they are referring to the Standard and Poor’s 500. It’s synonymous with the broad market.

Companies may be included in multiple indexes. For example, companies in the Dow Jones index (DOW) are also included in the Standard and Poor’s 500 index (S&P 500). Companies such as Apple Inc. find themselves in the aforementioned indexes, plus many technology-based indexes.

Pharmacology Example

We could have a beta blocker index. It would include all beta blockers – esmolol, labetalol, metoprolol, etc. And there could be a smaller index called the beta-1 selective beta blocker index – bye labetalol. A broader index would be the cardiac drug index.

Just know, indexes are a group of stocks specified by the title of the index. Companies are occasionally added and removed from various indexes. For example, as Tesla was growing in size and value over the past few years, it was added to the S&P 500.

For oversimplification’s sake, an index fund consists of one share of every company in that index. When you buy a share of an index fund, it might actually be 1/1,000th of each share of the 500 companies in a given index. Minimal buying and selling of companies as indexes don’t change that often.

Mutual Funds

I have worked with two professional financial advisors in my day, and this was their favorite investment. Dave Ramsey fans, I may rain on your parade a bit here.

A mutual fund is almost the same as an index fund because they are both large basket of individual stocks. When money goes into your Fidelity 401(k), Fidelity sends the money to a mutual fund manager to do your investing.

Mutual funds (and index funds) have a money manager to collect funds from everyone investing via Fidelity and to manage the fund. Some mutual funds are active, meaning there is a lot of buying and selling. Other mutual funds are passive, making them more like an index fund.

 Let’s take the S&P 500, which contains approximately 500 companies at any given time. An S&P 500 index fund contains one share of each company.

An S&P 500 mutual fund invests in the same 500 companies within the index. Unlike an index fund, they are not required to hold equal shares of each company. A fund manager might decide to avoid investing in a particular company expected to underperform the market because they tweet things like their stock price is too high. Yep, that was Elon.

The same fund manager might double down on Apple Inc. because he expects the new iPhone to sell like crazy. It’s like having a personal stock picker who looks to outperform the market while still holding a large, diversified basket of companies.

Pharmacology Example

A manager overseeing the Total Beta Blocker Mutual Fund  manages a fund willed with beta blockers. They increase their holding of esmolol because all of the cool kids are using it on induction. This means esmolol is set to increase sales and have a good year.

Betaxolol has been underperforming because of random fictitious reasons. The fund manager isn’t required to buy shares of betaxolol because this isn’t an index fund. So, they elect to spend your 401(k) dollars on cool beta blockers like esmolol.

Disclosure of Mutual Fund Contents

Mutual funds contain other investment vehicles like bonds and money market accounts among other things. Sometimes a fund manager wants to increase their cash position while they wait for a better time to purchase stocks. Just know, a fund manager is obligated to make investments based on the interest of shareholders.

Index Fund vs Mutual Fund

Which to invest in IF you have the option? Not all 401(k) plans have an option. If you self-manage, the entire investment world is your oyster. If Fidelity, Principle, or Charles Schwab run your retirement, you choose option A, B, or C.

Pros and Cons of Index Funds

The must-read list mentions The Little Book of Common Sense Investing by John C. Bogle. It’s an entire book about why index funds are superior to mutual funds. The late Bogle founded the Vanguard Group on the premise of index fund investing.

Bogle examined mutual fund returns over the decades and compared the returns to the S&P 500. Only a few fund managers outperformed the market. After accounting for fees, only a couple mutual funds outperformed the market.

Note, the expense ratio (fees to be in the fund) are charged regardless of how the fund performs for the year.

Bogle concluded the high fees charged by mutual fund managers decreased profits more than they were worth. The results cost investors six to seven figures over a career.

The suggestion based on statistical significance boils down to this:  Invest in passively managed, low-cost index funds and hold them for the duration.

Passively managed funds do not try to time the market and charge minimal fees because managers to minimal work. An expense ratio less than 0.2 is considered low cost. This means for every $1,000 you have invested; the manager keeps $2 annually. $1M invested -- $2,000 annually.

Vanguard offers many index funds with an expense ratio between 0.03 and 0.08. That $1M investment into a Vanguard index fund only costs $400 annually. Not too shabby.

This investment is easy and timeless. You can expect the market return, but you can only expect the market return.

Pros and Cons of Mutual Funds

It bugs me to no end how Dave Ramsey says just go out and find mutual funds consistently beating the market. Look for an annual 10-12% return when the market returns 9%. This isn’t realistic because it doesn’t exist after fees.

Mutual funds can outperform the market, but when the fees are added in, matching the market at a 9% annual return is considered a winning pick. The biggest upside is the chance of beating the market.

Fees are the killer. Usually, the more money you have invested with a fund, the cheaper it is. Prior to earning CRNA money, I had a couple thousand bucks with Edward Jones and Ameriprise. I was paying 1.8% annually for them to manage my money. Sad because they still underperformed the market.

 Typical fees linger just above 1%. As you approach the two-comma club, 0.5% may be more typical.

Expense ratios change depending on the work of the fund manager and their team. If the fund is actively managed where regular trading occurs, expect higher fees. Passively managed funds have minimal stock turnover which looks like an index fund.

A 1% fee on a $1M investment is $10,000 per year. Big difference from a $400 annual cost holding a Vanguard index fund. This means the fund needs to beat the market by 1% just to break even with an index fund. Sounds easy, but rarely happens over a 10- or 20-year term.

Mutual funds may have a front-loaded fee. This means if you are looking to move $100,000 to a fund, they may have a $5,000 cover charge just to get in the door. The annual fees are lower, but now you have less principle to compound.

Get back to the topic, what’s in my 401(k)?

Fair enough. The answer is a mix of index funds, mutual funds, and bonds housed within a Target Date Fund.

For the majority of an investing career, purchasing stocks via index funds and mutual funds is a strong option. I speak about it here in my post about the Factors of Wealth Building:  The Accumulation Phase.

The stock market has averaged just over a 9% annual return. Annual returns have been as high as 43% and as low as -36% during the 2008 financial crisis. The law of averages negates the troughs and valleys to leave us with a 9% return. Not bad.

I casually mentioned bonds, but haven’t explained why they are likely in your 401(k).

What is a bond?

There are a few types of bonds. At their simplest form, they are a way for companies and countries to raise money. For example, the U.S. government may offer a bond. When you buy a bond from the U.S. government, you are loaning the government money at a given interest rate.

The interest rate typically reflects inflation. The rate may be fixed or variable depending on the bond. Bonds have different repayment lengths. More on details of bonds another time.

Bonds are considered fixed income because you know the amount they will return every year. The stock market produces unpredictable returns, so it’s nice to have some stability knowing a portion of your portfolio will produce a positive return, even if that return is less than 9%.

It’s common to use the following formula to determine how much of your portfolio to allocate towards fixed income investments like bonds:

120 – Age = Percentage in Stocks

If you are 40 years old, it is commonly recommended to have 80% invested in stocks and 20 % in bonds. At age 65, look for a portfolio of half stocks and half bonds. There are many nuances to this. Read Asset Allocation: Keep it Simple for more.

Target Date Fund

Back to the Target Date Fund, the 401(k) option offered by Fidelity. We already discussed that a target date fund consists of index funds, mutual funds, and bonds. The beauty of the target date fund is the concept that it self-balances over time.

A Target Date Fund includes… you guessed it… a date in which you expect to retire. My investments are in a 2060 fund. Fund managers use something similar to the aforementioned formula to determine what percentage of investments should be allocated to each avenue as the target date approaches.

My Target Date Fund 2060 currently is stock heavy via the use of broad market funds. There are a couple bond funds, but mostly stocks. As the years pass, the fund manager will buy a higher percentage of bonds each year.

In the year 2060, I would expect a 50/50 mix of stocks and bonds for my portfolio.

A Target Date Fund will theoretically provide a high growth environment with a 40-year runway and a maintenance environment going into retirement.

Typical expense ratios for Target Date Funds fall between that of index and mutual funds. Target Date managers need to do a bit more work than index fund managers, but it’s not bad. The fees are so you, the investor, can put things on autopilot and never need to worry about asset allocation.

All of that is my wordy way of saying your 401(k) likely holds a mix of index funds, mutual funds, and bonds. Thanks for reading!