Your Most Important Investment Decision Ever

April 9, 2008 — -- The most important investment decision the average American faces has nothing to do with when to buy or when to sell.

Rather, it revolves around the choices we make when we enroll in a company 401(k) or similar retirement savings plan. How much you contribute, and how you invest those contributions, are among the most critical financial decisions we make in the 401(k) era.

The answer to the first question — how much to contribute — is easy: as much as possible. Just be sure to contribute enough to capture the full matching contribution offered by your employer.

The second question — how to invest those contributions — can be much tougher for many workers to answer.

Faced with a dozen or more mutual funds as investment choices, many 401(k) participants can be overwhelmed. Total market index fund or intermediate corporate bond fund? Red Hot Large Cap Growth Fund or Sky High Expenses Small Cap Value? Invest in one fund or a dozen?

If you're unsure how to proceed, let me suggest a four-step process you might want to follow.

First, review each of the investment options offered by your employer's plan. Try to determine into which investment category, or asset class, each fund fits.

In my view, you want four or five major categories represented in your 401(k) portfolio. These are large cap stocks, small cap stocks, international stocks, bonds and cash. Think of them as your portfolio building blocks. Younger workers can do without the cash holding; older workers will want to stash some there for stability purposes.

Other categories you might find offered in your plan include real estate, international emerging markets, international bonds and domestic mid cap stocks. Each of these can be a nice portfolio addition, but if too many funds overwhelm you, start with the five major categories. The others can be added later.

The second step is to figure out the best one or two funds in a given category. Compare not only past performance but also expense ratios. Myself, I would lean toward an index fund if available, but I find in many 401(k) plans that building an all-index portfolio is not possible. At best, you might be offered one index fund representing just a single asset class.

In most cases, one fund per category is enough, but if you find more than one choice you like, split your chosen portion for that asset class into two for the two funds. Don't double up in that particular category.

The third step in the process may be the toughest for investing newcomers. That is selecting the appropriate allocations for each investment category: What percentage of large cap stocks versus small caps, or cash versus bonds?

It's impossible for me to cover every possibility here, but I'd suggest you start first by figuring out how much you want in stocks compared to bonds and cash. The more aggressive and younger you are, the more you want to allocate toward stock mutual funds. More conservative and investors closer to retirement will want a higher percentage of stocks and bonds.

A moderate portfolio might include the following breakdown: 35 percent large cap stocks, 10 percent small caps, 20 percent international stocks, 30 percent bonds and 5 percent cash.

One thing to keep in mind is that going too conservative with too much allocated toward cash and bonds carries its own risks. Too much money in cash and bonds could mean your portfolio won't keep up with inflation and you could lose purchasing power.

For guidance, you may want to consult the asset allocations used by target date mutual funds geared toward investors of a particular age group. For instance, the Vanguard Target Retirement 2025 Fund aimed at investors in their late 40s, held about 78 percent of its money in stocks and 22 percent in bonds as of late February.

Details on the Vanguard target date funds are available at the mutual fund company's Web site. Similar offerings from other mutual fund families like Fidelity, T. Rowe Price and American Century can also provide guidance.

The fourth step in this process is to revisit your plan at least once a year to be sure your holdings remain in balance with the asset allocation targets you originally set. If you set a 20-percent allocation for international stocks and they've fallen to 15 percent, then it's time to move money from another asset category that has exceeded its target to international stocks.

This four-step process I have outlined assumes you are building your own portfolio rather than utilizing an all-in-one investment option like a target date mutual fund that takes care of the asset allocation process for you.

The truth is more and more 401(k) investors are likely to gravitate toward these funds as they look for simple solutions and target date funds become a more popular option. For those seeking a set-it-and-forget-it investment approach, target date funds can be an appropriate solution. Just be sure to scrutinize the expenses associated with these funds just as you should with other mutual fund options.

For those seeking a more individualized portfolio, the four steps outlined above can help you with what might be the most important investment decision you'll ever make.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning (www.fourpondsfinancial.com) in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com