A 401(k) is a tax efficient way to build a nest egg for your retirement years. Your employer deposits a portion of your pay into the account, which is generally composed of investment funds managed by financial professionals until you reach your golden years. If the money is invested in stocks alone, brace yourself for a roller-coaster ride since the fund will rise and fall with the market. Some of this turbulence can be avoided if the money is placed in fixed income funds. However, these investments can expose you to a new set of problems. Particularly if you overdo it.
Stocks Versus Bonds
Most people's 401(k) plans include growth and income funds. The stocks in growth funds represent a partial ownership stake in companies. If a company does well, its stock rises in value. If the company goes bust, you could lose everything. Income funds mostly contain bonds, which are basically loan agreements. You'll get regular interest payments when the company or government -- the bond issuer -- borrows money from investors. The interest goes into the 401(k), which should slowly fatten over time. Since most 401(k) investors put money into bond mutual funds instead of bonds issued by individual companies, their money is spread among thousands of corporations and government entities. This tends to provide a hedge against defaults, which usually only affect one or two entities at a time.
If a company goes bankrupt, bankruptcy court will settle the claims of bondholders in full before it even talks to stockholders about getting any of their cash back. This makes bonds safer than stocks. Because of this -- and because the income you can expect to receive from bonds is small and limited -- bond prices tend to remain fairly steady. Stocks, on the other hand, have unlimited growth and loss potential. People close to retirement age often move money from stock funds to income funds because preserving capital matters more to them than growth. If you don't plan to retire for 20 or 30 years, you will unnecessarily limit your growth potential if you move all of your money to fixed income funds.
Market losses are not the only potential threats to fixed-income investments. Inflation can effectively lower the value of income funds. Creditworthy borrowers, such as the federal government and major corporations, pay low interest rates on their debts because they have minimal default risks. Because of this, over time, inflation may grow at a faster rate than a bond-heavy 401(k) can grow. Since rising prices reduce your spending power, you are effectively losing money over time if the inflation rate is, say, 4 percent and your bond fund yields only 3 percent.. So you can typically preserve your initial investment in a fixed income fund, but you can't preserve your spending power.
Poorly managed firms have just as much access to debt markets as well-run companies. Some investors happily buy bonds from struggling firms because the interest rates on these debts are much higher than on the bonds issued by stronger entities. High yield, high risk bonds often sell for a premium because some investors are desperate to earn that high interest. These funds are sometimes just as volatile as stock funds. Keep in mind that these high interest rates mean extra risks, and you won't make a lot of money on fixed income investments if the bond issuers all go broke. Some of the biggest corporations in the world failed during severe recessions, leaving bondholders with little or nothing. Anybody remember Enron? WorldCom? Lehman Brothers? Their bondholders would prefer to forget.
Rather than putting all of your eggs in one basket, you can invest in a mix of growth and income funds. If your employer makes matching contributions, you can even invest your own cash in conservative bond funds and risk the company match on stock funds. Even if the market goes down today, your account still has a few decades to rebound before you need the money. You can regularly review your investment selections and gradually reduce your stock holdings as you near retirement.