401(k) allocations: divining the future

Managing a 401(k) involves two decisions: Where to invest current balances, and where to put future contributions. Today we’re going to deal primarily with the latter. You’re continually shoveling money into a 401(k), and it would make sense that how you direct that money could affect performance.

We conducted a small experiment to see whether there’s any reasonably simple strategy for making the most of your new contributions. Let’s assume that, 20 years ago, you had $10,000 in a 401(k). You put $2,000 apiece in a large-company stock fund, a midcap stock fund, a small-cap stock fund, a government bond fund, and a corporate bond fund.

Each year, you contributed $2,000. Had you simply split your money evenly between the five options, you would have had $149,201 by Sept. 30, according to Lipper. (In case you’re wondering, we used Lipper’s indexes for each type of fund. The indices measure the performance of the largest funds in each category.)

But what if you had funneled your money into the previous year’s laggards? In 1988, for example, you would have invested $2,000 into small-company stock funds, which tumbled 5.5 percent in 1987. You would have picked a winner, too: Small-cap funds soared 20.3 percent in 1988.

Overall, however, the strategy actually detracted from performance. Your account would have ended September at $146,800, a bit less than if you had simply split your new contributions evenly amongthe five funds. There are several possible explanations for this.

First, and most plausibly, is that stocks tend to outperform bonds. By putting your money into the worst-performing option, you would have tended to add to your bond funds fairly frequently. In fact, your $2,000 would have gone to government bond funds 11 years out of 20.

Secondly, one bad year in the stock market is sometimes followed by another. The strategy would have put you in midcap stock funds in 2002, which fell 18.5 percent in 2001. The funds plunged another 25 percent in 2002.

Interestingly, if you had put your new money into the previous year’s winners, you would have fared slightly better, ending September with $151,000 in your account. This, too, makes a bit of sense: Overall, stocks had more winning years than losing ones the past 20 years.