There are several reasons why an employer-sponsored 401(k) plan is such a popular way to save for retirement, not least of which that it is funded with pre-tax money and grows tax deferred. But just as important to a plan’s success is how contributions are invested.
We might suggest that, at a minimum, your 401(k) should contain a mix of assets that meet your particular retirement goals and suit your tolerance for risk.
And what’s the best way to accomplish that seemingly difficult task?
The model portfolio approach has become increasingly popular among retail investors, and here is why: They easily help participants diversify their portfolios and create a risk/return profile that suits their specific needs.
401(k) providers typically offer model portfolios based on a mathematically constructed asset allocation approach. The portfolios usually have names like Conservative, Moderate, Balanced, Aggressive, or Growth, and they are crafted so that each model has the right mix of assets for its stated level of risk. In practice, a manager will rebalance the funds to align with the strategy you choose.
So how do you decide which model portfolio is right for you?
1) First, determine your age and how long you have until retirement. The longer timeline you have, the more aggressive you can afford to be.
2) Next, think about how much risk you are actually comfortable taking. Some people with a longer time horizon may not be comfortable with an aggressive portfolio, so a moderate or growth portfolio would make more sense.
3) Finally, make sure the allocation really makes sense to you. It is important to understand the risks and exposures of each portfolio before selecting.