With its tax advantages and compounding magic, the 401(k) is likely to be one of the most powerful instruments in your retirement toolbox. But take care when managing this account: A few missteps can make a difference of thousands of dollars down the road. Here are seven potentially costly 401(k) traps, paired with advice from the pros on how to avoid them:
Ignore asset allocation. Believe it or not, the most important decision you'll make as an investor isn't which funds you buy. A bigger key to your portfolio's long-term success is how you divvy up the money among different types of stocks and bonds. "If you get the allocation wrong, there's nothing you can do as far as finding funds or managers to fix that problem," says Ron Florance, director of asset allocation and strategy for Wells Fargo Private Bank. Need some guidance? An asset allocation calculator can help you determine your best mix.
Load up on bonds. When you have decades of compounding growth ahead of you, a heavy allocation to bonds can act as a drag on your portfolio. Young investors should take advantage of the current market volatility by contributing mostly to stock funds, advises Kelly Kratz, a Lawrence, Kan.-based field consultant for TIAA-CREF. "It's important during the growth stage to let the market work for you," she says. "I can't tell you how many individuals I've met with at the beginning of retirement who say they wish someone had told them to be more aggressive when they were young."
Blindly pick funds. Don't lull yourself into a false sense of diversification, says Stephen Barnes of Barnes Investment Advisory in Phoenix. "Many times, participants own a lot of funds that seem different, but when you look closely, they own very similar stocks," he says. The bottom line: You can't rely on the name of a fund to tell you what it contains. A quick way to get a sense of a fund's style and holdings is to look it up on Morningstar. (After typing in the fund's name, select the "portfolio" tab on the left side of the page.).
Bet it all on a few good stocks. One big advantage of mutual funds is that they can diversify by investing in a basket of stocks. But take a close look at the basket, because it might hold 100 stocks, or it might hold just 20 or 30 (what's known as a concentrated portfolio). "Look how much of a fund's assets it has in its top 10 stocks," says Daniel Crimmins, founder of DPC Wealth Management in Ramsey, N.J. "If it has 50 percent of its money in 10 stocks, that's a risk factor." That doesn't mean you shouldn't invest in concentrated funds at all—just make sure you're diversified elsewhere.
Get hung up on past performance. It's important to maintain a diversified mix of investments, even if the historical performance of an asset class has been less than desirable. "Owning things that go up and down at different times can add multiple percentage points to your return over time, even if some of the underlying funds don't perform well," Barnes says. So even if large-cap value funds are down this year, they'll help cushion the impact when your growthier funds run out of steam. It pays be contrarian, says Barnes, and add to funds that haven't been performing well. "Like Robin Hood, steal from the rich and give to the poor," he says.
Miss the match. Would you throw away free money? Surprisingly, a third of 401(k) participants recently surveyed by Palo Alto, Calif., advisory firm Financial Engines are doing essentially that, by failing to contribute enough to receive their employer's match. A common match is 50 cents on the dollar, up to 6 percent. For a worker who earns $50,000 and sets aside 6 percent a year ($3,000), the company chips in $1,500.
Go gung-ho with company stock. Most advisers recommend investing no more than 10 percent of your 401(k) in a single company's stock—including your employer's. In case you don't remember what happened at Bear Stearns or Enron, loading up can be a dangerous proposition should the stock tank. According to Financial Engines, more than a third of participants have at least 20 percent of their portfolios invested in company stock. Even more alarming, a quarter of participants over age 60 have 50 percent or more of their 401(k) money riding on company stock.