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Making the Most of Limited Investment Choices

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Posted May 26 2010 01:14 PM

Most company sponsored 401(k) and 403(b) plans offer limited investment choices. To make the most of those choices, look at all the options offered by your different accounts (your company’s 401k, your spouse’s 401k, and so on). If one of your accounts offers great choices in a particular area (stock funds, say), use it for that segment of your asset allocation. You can use your IRAs, taxable investment accounts, or other investment accounts with a variety of choices to fill in the gaps in your allocation, such as small companies or foreign investments. You can see an example of this in the table below. Say your spouse’s 401(k) has a great menu of foreign stock funds, so you put your foreign stock allocation there. Your IRA has bond funds galore, so you invest bond money in it. If all your accounts have good U.S. stock fund choices, come up with a division for U.S. stocks based on what you think of the choices in those accounts.

Asset Class Your 401(k) Spouse’s 401(k) Your IRA
Large-cap U.S. Stocks 50% 50%  
Mid-cap U.S. Stocks 50% 25% 25%
Small-cap U.S. stocks   50% 50%
U.S. Bonds     100%
Foreign Stocks   100%  

Bonds versus Bond Funds

Bonds and bond funds don’t work the same way. If you own an individual bond, you can sell it whenever you want to—at maturity, when the bond’s market value is higher than its face value, or when you simply need the money. Bond funds, on the other hand, have to sell bonds when fund investors redeem their shares, regardless of market conditions. By the same token, they have to buy bonds when current bonds mature or when investors add to the fund, whether or not the market’s favorable. All this means that interest rates affect the returns of bond fund investors more than they affect the returns of individual investors who can pick and choose when to buy and sell their bonds. The table below compares the features of bonds and bond funds and explains why you might choose one over the other.

Bonds Bond Funds
Bond pricing may make it hard for individuals to invest. Bonds have fixed incremental costs of $1,000 (if you buy them when they’re issued), and you can’t buy just part of a bond. You can invest small amounts of money and contribute on a regular schedule.
You can buy bonds based on their maturity date, so that they mature when you need your money back. You can reinvest dividends into the fund.
You can hold a bond to maturity, so you won’t lose money. You can get to your money with less risk than selling a bond before it matures.
You can earn capital gains if interest rates fall, thereby increasing the value of your bond (although most individual investors don’t bother with this aspect of bonds). You can earn capital gains from increasing bond prices if interest rates fall.
Commissions to buy new-issue bonds are lower than mutual fund expenses. Bond funds diversify your bond investments, which reduces your exposure if you choose to invest in lower-quality but higher-yielding bonds.
Personal Investing: The Missing Manual

Learn more about this topic from Personal Investing: The Missing Manual.

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