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Investing Retirement

Risky or conservative? A guide to setting up your first 401(k)

  • 5-min read

You don’t need to be a rocket scientist to figure out your 401(k). The key to your future wealth is simpler than you think.

A stock ticker that says “asset allocation”
iQoncept / Getty Images

You’ve already heard that your 401(k) is one key to securing the cushy retirement that we envision in our deepest pits of despair — like, the ones when the only light your face has seen in the past two weeks is from your LCD monitor — but you might not have heard about the best way to get it set up.

Keep reading for a guide to choosing your first investments within your shiny new 401(k) plan. I promise it’s less boring than that show you’re continuing to binge watch out of a sense of social obligation.

What are my investment options for my 401(k)?

First, a 401(k) is not actually an investment: It’s a section of the US tax code that allows for employer-sponsored retirement plans to benefit from tax deferral.

Most, if not all, of your 401(k) plan options are actually mutual funds that buy a collection of stocks and bonds on your behalf. A few plans also offer annuities — a type of insurance product — but if you see that, pull a Nancy Reagan and just say no: Annuities are often loaded with hidden fees and are generally unsuited to young people. Mutual funds will do you just fine.

You came here to talk about asset allocation, which is the portion of your contributions allocated across different assets, including stocks and bonds. There is no best 401(k) option for everyone: It ultimately comes down to your willingness and ability to take risk. 

Your willingness to take risk is determined by your personality. Are you the kind of person who gets the bad kind of butterflies in your stomach when you hear about the stock market going down (or when your crush takes more than 10 minutes to respond to your texts)? Or are you the kind of person who usually thinks market downturns are a buying opportunity? If you’re in the latter category, you have greater willingness to take risk and therefore would allocate more to riskier assets, like mutual funds that lean heavily in risky stocks.

Your ability to accept risk is primarily determined by your income and age. The higher your income — and the younger you are — the higher ability you have to take on risk. It also hinges on your personal obligations; if you’re providing for a family, you probably aren’t putting your entire IRA in Dogecoin.

Your willingness to take risk is determined by your personality. 

Your ability to accept risk is primarily determined by your income and age.

Chris Baines

Meet Dylan, the risk taker: 100% stocks

Dylan is a 21-year-old investment banking analyst making $100,000 a year with $9,000 remaining in student loans at a 6% interest rate and no other debt. He enjoys poker and is single (despite his mother’s best efforts). Dylan is lucky: If he were to become unemployed, he could gain temporary work at his father’s business.

Dylan’s circumstances and personality call for a 401(k) portfolio with no bonds and loads up on stock-heavy mutual funds. And since diversification is the only “free lunch,” and the US isn’t the center of the universe anymore, Dylan puts a considerable amount in international stocks. His aggressive portfolio has a 60/40 split between domestic and international equities, with the international component divided again between developed and emerging (aka riskier) markets.

As for a Roth vs. traditional 401(k) debate, it depends on whether he thinks he’ll be in a higher tax bracket in retirement. A man of Dylan’s temperament is optimistic, which points towards the Roth (taking the tax hit now, expecting his income and tax bill will both be higher when he’s gray).

Meet Joe, the risk-averse actor: 80% stocks, 20% bonds

Joe is a 23-year-old actor who works at Starbucks for its 401(k) plan and health insurance. His annual income swings violently between $35,000 and $150,000 depending on what acting gigs he gets. He’s saddled with $25,000 in student loans at a 6% interest rate and no other debt. He enjoys spelunking (cave diving!) and is engaged to his college sweetheart who is unemployed and trying to get her first romance novel, St. Elmo’s Gorge, published (know any literary agents?).

At first glance, it might seem like Joe would go for a high-risk allocation like Dylan. But Joe’s ability to take risk is compromised by his higher debt load, relationship status, and — most importantly — his unstable income. The unpredictable nature of the acting profession means it’s more likely he’ll need to tap into his savings for some unforeseen expense. And if it gets bad enough, that could include raiding his 401k, penalties-be-damned. Because he may need the money sooner than Dylan, his time horizon on a probability-weighted basis is shorter than Dylan’s. So, Joe has adopted a less aggressive asset allocation.

To minimize the chances of ever needing a 401(k) withdrawal, Joe’s working on setting aside at least six months of expenses — enough to cover him and his betrothed — to make sure they’re both protected from a drought in acting gigs. Once his cash load is as comfortable as the water bed he sleeps on, he’s going to split his savings between paying off student loans and buying stocks in his 401(k). After his loans are paid off, he plans on 80% of his 401(k) contributions being in stocks, and putting the remaining 20% in bonds: He is young enough that being predominantly — but not totally — stock-oriented still makes sense despite his unstable income.

How often should I rebalance my 401(k)?

Your portfolio’s current asset allocation will fluctuate depending on how markets have performed, which means you might want to rebalance toward your target allocation periodically.

Which brings us to a dirty secret:

There is no agreement among experts on the optimal rebalancing schedule. Indeed, some finance experts argue against rebalancing at all. The fact that opinions are so varied tells you that this is not a decision you should lose sleep over; the key is to just to consistently stick by whatever rule you choose, even when emotionally difficult. 

My two cents: I like what’s called a “tolerance band” approach, which is when you rebalance the portfolio after — or only after — a certain deviation from the asset allocation has occurred. For example, if I set a 10% tolerance band, it would mean that when my allocation strays from that allocation by 10% or more, I would rebalance. This allows you to capitalize on major dips and peaks without waiting for the calendar to hit an arbitrary day.

Don’t sweat it

The biggest mistake isn’t picking the wrong 401(k) option: It’s not bothering to invest at all. So don’t let the “did I pick the right option?” keep you up at night: You’re already ahead of the pack.

Or…forget I said anything about asset allocation and investments and just use a target-date retirement fund.