401(k) Diversification Isn’t Working


I I’m sure casual 401(k) investors have read at least one article about asset allocation and dollar cost averaging, as well as the virtues of diversification. These are the three pillars of the financial service provider marketing theme. Your 401(k) provider web site will be happy to help. They can fill the rest of your day with these familiar 401(k) investment management strategies, as well as a wide range of resources and online tools to help you get started.

But both stocks and bonds fared poorly in 2022, and a standard 60% stock/40% bond portfolio did its worst in years. So far in 2023, 401(k) investment returns haven’t been much better. The 401(k) accounts I’ve reviewed recently hold in value because of contributions from year to year. Recent 401(k) investment returns have many investors wondering how to protect their portfolios from stock and bond market losses for the rest of 2023.

Here’s a hint: Don’t follow popular 401(k) investment management strategies. Your annual investment performance will take a hit, and you deserve better. The first problem with diversification is with bond prices. Inflation has been a killer, and the Federal Reserve has been raising interest rates to get it under control, with no end in sight to rising rates. When interest rates rise, bond prices fall. Worse, many 401(k) bond mutual funds invest in long-term bonds, which fares the worst when interest rates rise.

The Federal Reserve raised interest rates again on May 3, and since March, US interest rates have increased by more than 5%. Can You Afford a 5% Increase in Your Home Mortgage Rate? Then don’t expect your 401(k) bond mutual fund to outperform. Long duration bond mutual funds may not provide the much needed diversification. The popular target mutual funds found on most defaulted 401(k)s are now at high risk of principal loss.

Until interest rates stop rising, diversification won’t prevent further 401(k) principal losses. The Federal Reserve has been clarified. If the rate of inflation does not decline, interest rates will rise further, and bond mutual funds will continue to lose more principal value in the future. The reality is clear: The relationship between stocks and bonds has undergone a dramatic secular change and 401(k) investors need to adjust their risk tolerance and investment objectives.

Interest rates have been on a downward trend for the past three or four decades, but since the beginning of 2022, the trend has been largely reversed. The long-term historical correlation between stocks and bonds shifted from negative to positive, and 401(k) investor principal losses occurred thanks to both stock and bond market losses, a rare double whammy for any 401(k) investor.

The best asset class for protecting your 401(k) principal is money market funds. Because it’s boring and predictable, it’s never been a popular 401(k) investment option, according to company 401(k) providers. In most years, I would have agreed, but not now. A 401(k) now has major exposure to both stock and bond mutual funds.

Don’t feel overwhelmed by the responsibility of managing your 401(k) because right now, your number one goal is clear: preservation of principal. Don’t lose any more money with a “buy-and-hold” 401(k) investment management strategy. “Set-it-and-forget-it” has also failed once again, like it does every few years. The economics, interest rates and stock market environment have changed. Individual 401(k) investors should change their retirement plan investment objectives.

For 401(k) principal growth to happen again, interest rates must stop rising and stock prices must resume upward, which makes this a difficult task, so until then, 401(k) Principal preservation is your number one investment management goal.

The views and opinions expressed here are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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