How I Chose my 401k Asset Allocation:

The FI community primarily focuses on a “set it and forget it” approach to investing.  I believe this is the way to go for most people. But how do you know you’re selecting the right investments now, to make sure you have to do as little as possible going forward?  The keys to this are diversification and low expense ratios. I’m not a stock market genius, so when I started out trying to find the best places to put my money, I looked at the 3 biggest names in investing: Vanguard, Fidelity, and Schwab.  Between them, they have over $10 trillion under management!

I’m not a CFP, nor do I claim that this is what you should be doing with your own money.  This is simply what I do, and how I arrived at the allocation/fund selection that I did. I encourage you to do your own research and let me know in the comments how our approaches and asset allocation differ – would be very interested in comparing and hearing your reasons why you invest the way you do!

Also, I’m currently 100% stocks.  I’m young and stocks have a higher expected rate of return, so for now I’ll stick with that in the hopes that it results in more money in my pocket when I’m older.  I don’t know when I’ll incorporate bonds into my allocation, but I don’t imagine it’ll happen until the age of 35 or older.

Diversification:

 

Now that we have this established, let’s talk about diversification.  More specifically, asset allocation between the US and International markets, as well as a market cap weighted allocation for the US portion of that.  For this, I looked at the target date funds of the big 3 brokerage firms I named previously. These are one-stop-shop funds that change their allocation of stocks and bonds as time progressing so that you don’t have to worry about it, and the to pay for this is a higher expense ratio, so I decided to do it myself.  The funds are made up of 4 underlying funds: US stocks, INTL stocks, US Bonds, INTL bonds. Since I’m 100% stocks, I only looked at this bit. For example, the Vanguard 2060 Target Date Fund (VTTSX) has 54.1% US stocks, and 35.9% INTL stocks (the remaining 10% being bonds). This puts the US vs. INTL stock weighting at 60-40 – easy enough!  I have no reason to think these are bad approximations for approximating the total world stock market with respect to market cap, and since I’m banking on it all to go up, I’ll trust the experts!

Next, for the US portion, I needed to determine my allocation between large, mid, and small cap.  The reason I needed to do this was because my 401k doesn’t have a Total US Market fund that it offers, but it does have individual funds for large, mid, and small cap.  Quick definitions: Market Cap = (price per share)*(shares outstanding), and large/mid/small cap is defined by companies where market cap is >$10B/$2B-10B/<$2B respectively.  I needed a way of approximating the total US stock market (essentially my own version of VTSAX). I found this(https://www.bogleheads.org/wiki/Approximating_total_stock_market) and it has a handful of different approximations.  I chose the first one on the list since it approximates VTSMX.  It estimates 73% large cap, 18% mid cap, and 9% small cap. With these two weightings, I was able to select the correct proportions in my 401k.

 

Expense Ratios:

The entire reason I began to look into this was I’d read online “avoid high expense ratios!”.  Seemed like a simple enough rule. 0.04% is a small number and 1% is a big number. Small number = good, big number = bad.  Once I read this, I checked out my 401k. I was invested in the default fund, a 2055 target date fund, with an expense ratio of 0.72%.  And after applying the logic from my above findings on asset allocation, I changed from the target date fund to my very own 4 fund lazy portfolio.  And between these, my new weighted average expense ratio dropped down to a very minimal 0.026%. I’ve come to find this is VERY low, which is great (nearly 30x less fees)!  Fees this low won’t always be possible due to the available funds from your own 401k plan, but from what I can tell, if you’re in a target date funds and have other options to approximate the total market, it’ll likely give you the same expected returns while lowering costs.

This little chart highlights the differences between a low and a high expense ratio (in this particular case, my 2 available options).  As you can see, the differences are subtle for the first 10 years, but if we extrapolate out to 20, it jumps to a $50k difference!

 

That’s how I went about approximating the total market.  How did you accomplish this? Or do you use a target date fund, or maybe even just 100% in a S&P 500 fund?  Let me know below!

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