Three Steps to Break from the Herd and Invest Your 401(k) Like a Millionaire

If you’re saving for retirement, chances are you’re doing it primarily through a 401(k) plan. And I bet you’re not using your 401(k) very wisely.

For many reasons, not all of which relate to corporate America’s concern for its workers’ financial futures, the 401(k) has become America’s single largest savings vehicle. But given that these accounts represent the biggest chunk of many investors’ retirement savings, it’s surprising that most people are content to let their employer limit their options for investing it. And it’s shocking how few know what’s happening behind the scenes or bother to ask why.

Chances are, your 401(k) plan comes with a menu of mutual funds chosen by your employer in conjunction with the company they’ve hired to administer the plan. Those funds are probably a typical range of mutual-fund investments—a mixture of large-cap, mid-cap, and small-cap U.S. stock funds, a few bond funds and maybe an overseas stock fund or two. The vast majority of 401(k) plans wind up with something like 70% of their capital in large-cap, long-only funds dominated by stocks like Apple, Exxon Mobil, IBM, Microsoft, Chevron, Proctor & Gamble and Johnson & Johnson. The other 30% ends up in a few aggregate bond funds stuffed with U.S. government debt.

Why? There are roughly 8,000 mutual funds in existence, yet many companies have a genuinely rotten record of choosing the best ones for their employees. As Forbes reported last year, Walmart, the mighty discounter, because it offered just 10 mutual funds, many of them middling performers and most charging the same fees that the employees would have paid buying them individually. The expense ratios went as high as $1.66 for every $100 invested. Walmart had signed a non-disclosure agreement with Merrill Lynch, which was managing the 401(k) plan, so none of the 1.2 million workers in its plan could find out if Merrill was collecting distribution fees from the fund companies of the 10 funds it selected. In the lawsuit, the employees claimed that Walmart had cost its workforce $140 million in unnecessary charges.

The mega-retailer has since reconfigured the menu of funds to include several low-cost funds appropriately priced for institutional investors. And some companies have done a decent job managing their employees’ financial futures. IBM, Boeing and Lockheed organize collective trusts to give their workers access to funds with institutional rates. Unfortunately, it’s still perfectly legal for the administrators of your 401(k) plan to garner marketing fees from the mutual fund companies who’ve fought for a place on the short menu of funds your employer offers.

Savvy investors who prefer not to follow the herd know there’s a better way. They’re not bound by their employers’ investment choices. And the truth is, you’re probably not either. In fact, with a few simple steps, you can seize control of your 401(k) accounts, using them like an open-architecture brokerage account to invest your retirement savings however you’d like.

By the way, don’t feel bad if you weren’t aware of what I’m about to tell you. Few employers make it clear to their employees. Even the high-net-worth clients who come to my advisory firm—many of them successful business owners who contributed to a 401(k) alongside their employees—often had no idea they could use their retirement accounts this way.

Here’s what we tell them—and every investor should consider taking this advice.

Step 1. Find out if your 401(k) provider has the “self-directed brokerage” option.

The majority of 401(k) providers allow investors to convert their plans into open brokerage accounts by electing the self-directed option. But the option has to be enabled by your employer in its plan adoption agreements. If your plan doesn’t offer this option, start agitating for it with whoever’s in charge of the plan at your company.

If you’ve got the self-directed option, you’ll next want to notify your plan administrator that you want to elect it. They’ll get you the necessary paperwork, which you’ll fill out and be on your way.

A couple of important notes here. First, many 401(k) providers and employers will only let you put 50% of your vested balance into the self-directed brokerage account. Also be aware that your 401(k) provider will have a custodian hold your brokerage account. You must use their custodian. You cannot choose your own. This is because the provider and record-keeper need access to your account balances to fulfill reporting requirements with the Department of Labor and the IRS. Finally, your provider will most likely charge an annual fee for electing the self-directed account. This fee will probably range from $50 to $300 per year.

Now here’s the upside: Once you move to a self-directed account, you will be able to manage your account like any other online brokerage account. You’ll no longer be forced to order off the investment menu your provider and employer chose for you. Instead, you can invest in almost any stock, bond, mutual fund, ETF or closed-end fund you want. Most 401(k) providers will limit options trading to covered calls only, just like an IRA, but otherwise the possibilities are wide open.

Step 2. Now that you’re out in the open water, consider hiring a good guide.

I suggest working with a registered investment adviser—one who is regulated by the SEC and bound by a fiduciary duty. Many brokers steer clear of this registration; it can be a minefield, and regulators don’t take kindly to advisers whose bad ideas wind up draining their clients’ retirement savings. (I won’t expend too much energy on this subject now, but it is a real shame. The result is that most Americans get little to no advice on how to invest the biggest chunk of their long-term savings.)

Step 3: Start investing—but never forget what’s at stake.

Your 401(k) is likely your largest retirement asset. So be very cautious and manage your risk. For my clients, that usually means diversification and non-correlation—that is, making sure they’ve hedged a certain percentage of their nest egg on the downside, so that they’re not in the same boat with everybody else when bad news out of Greece sends the S&P down 20%.

There are plenty of ways to diversity, but with your 401(k), one simple way is to deploy some capital to a short mutual fund—active, open-ended funds that short the market. Most investors are usually 100% “long” on the market—meaning you make money when the price of your investment goes up. “Short” is when you make money when the price of the investment goes down. The idea is to still be “net long” but reduce your volatility. Note that there is no way you can do this in most 401(k) investment menus—they are almost always restricted to long-only funds.

Suppose for a moment that you’re an older investor who would like her retirement funds to swing less wildly than the stock market has in the past four years. There are plenty of these short funds out there. To get a sense of some and what they can do, check out this cart, generated using data from Morningstar. It shows four of the best-performing short funds over the last five years. Note that I’m not recommending that you invest in any of these funds, just showing you how they’ve done in the past five years.

SOURCE : http://www.forbes.com/sites/joshuarogers/2011/10/20/three-steps-to-break-from-the-herd-and-invest-your-401k-like-a-millionaire/