Sharpen Up Your 401(k)

Don't let the stock market rally make you complacent. Here are five tips to fine-tune your retirement account

by Alex Halperin

The stock market has been hot of late, but that doesn't mean you can retire just yet.

For many investors, watching their 401(k) plans has been a pleasure in recent weeks as corporate earnings and M&A activity have lit a fire under the major indexes and sent the Dow Jones industrial average to new record highs and the Standard & Poor's 500-stock index back above the 1500 level (see BusinessWeek, 5/14/07, "Now For The Real Market Peak").

That said, longtime 401(k) holders are no doubt cognizant that it has taken major indexes several years to return to their earlier peaks, reached in 2000 (the Nasdaq composite is still a long way away). The collapse of the dot-com bubble, and many a retirement plan with it, still looms large in the public memory.

So by all means, investors should enjoy their suddenly flush 401(k)s. But they should also keep in mind that bull markets inevitably end, and that a little preparation may help them maximize their benefits to their nest eggs from the recent bull run. This week, "Five for the Money" takes a look at strategies for investors to make sure they don't see their retirement plans' recent gains melt away as they did earlier in the decade.

1. Don't ignore fixed income

Though he doesn't believe in market timing, Plymouth (Mass.)-based financial planner William Driscoll says 401(k) holders should seriously consider having a fixed-income component in their plans. When major stock indexes are booming, he suggests "this is an opportune time to make the move" before a market plunge erases gains.

As many 401(k) holders know, fixed income allows investors to keep a portion of their plan in an unexciting account that pays out in the neighborhood of 5% (based on current rates)—around the levels of a high-yielding money market account. Of course, for younger investors in search of decent returns, most planners wouldn't recommend putting all of an investor's assets in the staid fixed-income section of the portfolio. But typically as one gets older it's a smart idea to lock in previous gains. Driscoll recommends young people keeping 8%-12% of their holdings in fixed income while middle-class people close to retirement should typically have about 40%.

2. Cover your downside

Investors exposed solely to market gains have cheered in recent months as broad indexes like the S&P 500 and Dow industrials have soared. But when they inevitably dip from these highs, those investors will take more than their fair share of losses; a pure S&P 500 index fund will rise and fall 100% with the index. For that reason it's a smart idea to have some way to reduce losses from when the market turns sour.

Traditionally this slot in a portfolio would be filled by a bond fund such as iShares Lehman Aggregate Bond (AGG). But Thomas Meyer, CEO of New Jersey financial advisory firm Meyer Capital Group, says that this section of a portfolio can be better filled by a long-short fund such as Diamond Hill Long-Short A (DIAMX) fund. (See BusinessWeek.com, 4/12/07, "Five Plays for the Pessimistic".) The ideal division, he says, is a portfolio that will track a mainstream benchmark up 80% but only capture 40% of its losses. More power to those investors who can pull it off.

3. Diversify and rebalance

These quintessential rules of investing apply to 401(k)s as well as normal portfolios. For Florida-based financial planner Keith Singer, that means exposing portfolios to international markets. With about half of the global market cap coming from outside the U.S., he says about 30% of a portfolio should be international.

The flip side of diversifying is maintaining vigilance to ensure that a portfolio doesn't become overexposed to any particular geographic area or industry.