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Centex wrote:

So, back to the original question:
Does the allocation they recommend pass muster for someone 20 years from retirement, or does it totally suck, or what? :-)

Well, the answer to your question depends on what else you hold in your portfolio. But the short answer is that I think the allocation "passes muster" for you if it's a stand-alone investment, especially in light of the fact that you already hold a small cap IRA. If you do have any other investments, though, you'll want to think about how your 401(k) allocation fits into your total portfolio.

Looking at your recommended allocation, the first thing I did notice is that there's a lot of overlap among the funds. Many of them explicitly hold the same indexes, albeit in different percentages. That's not an inherent problem as long as (a) you're aware of it, and the implications, and (b) you don't get stuck with any additional fees, such as those Vanguard levies on smaller accounts (see the recent "Roth IRA" postings on this board). If you DO get stuck with extra fees for small amounts in the funds, you'd be better off consolidating, since they overlap already.

Let's look at what they're recommending, once you disaggregate/reaggregate each fund:

25% S&P 500
25% Russell 1000 Value
22% Russell 3000
16% EAFE
8% Bond
5% Interest

That's 72% U.S. equities, which makes total sense when you've got a 20-year time horizon. Notice, though, that you're definitely weighted toward large caps. The S&P is large caps, so is the Russell 1000 (with a very high correlation to the S&P, though it's a bit broader index), and I think about 90% of the Russell 3000 market cap is the Russell 1000. So only ~2% of this portfolio is in small caps. That doesn't trouble me too much for you if your IRA is small cap-oriented, but depending on the dollar amounts it's a possible concern.

I do like that you've got some tilting toward "value" holdings by using the Russell 1000 value index. "Value" stocks will tend to have higher dividend yields, and thus, you'll take more advantage of the 401(k)'s tax exemption on dividends (particularly important if you have other outside investments and are in a higher tax bracket).

I also like that they've got you with some international exposure. Too many American investors, I think, invest in only U.S. equities when both theory and empirics suggest you can get a higher risk-adjusted return with some portion of your portfolio invested internationally. However, though I'm not an international tax lawyer or accountant, I'm pretty sure you lose some of the 401(k)'s tax benefits by holding international funds, because you pay overseas tax and don't get to claim a foreign tax credit to the IRS. Though this won't make much of a difference now, over the long run it can matter; therefore, in a few years, you may wish to begin accumulating some international funds in your taxable accounts and shift away from them (tax free) in your non-taxable accounts. Also, realize that the EAFE index essentially gets you Western Europe and Japan; if you want some emerging markets exposure (for a small percentage of your portfolio), you'll need to get it elsewhere.

As a general principle, I you should focus on 3 main principles in your 401(k) decisions:

1. Your overall portfolio composition and goals -- Unless your 401(k) is all you're saving for retirement, you'll want to fit it into your overall portfolio scheme. Thus, especially in the early years, you might focus principally on diversification away from other holdings if you're overconcentrated outside your 401(k). In addition, over time, 401(k)s can be ideal vehicles for portfolio rebalancing, since you can do it tax free (just make sure you don't get stung by fees from the funds you're holding).

2. The outside availability of 401(k) options -- If you have the opportunity to get into investments you can't buy on your own (e.g., hedge funds, private equity investments, various leveraged bond or equity funds), you may wish to focus there, assuming you have outside holdings and/or the capacity for substantial investment outside the 401(k).

3. Tax considerations -- As I've stressed elsewhere in this chain of replies, if you have holdings outside your 401(k) and IRA, it's advantageous to focus the tax deferred accounts on high tax holdings (i.e., those that realize high current income through high dividend/interest payouts and/or turnover-related capital gains), while focusing taxable accounts on low tax holdings (i.e., those that realize low current income by paying little or no dividends/interest and having lower turnover). In beginning years, this principle isn't crucial; but over time if you forget it you're throwing away a lot of money (or contributing it to the government, depending on your political philosophy). E.g., you might put higher dividend "value" equity holdings in your 401(k) and lower dividend "growth" holdings in your taxable accounts (assuming that your regular income tax rate is substantially higher than the long-run capital gains rate; if you're a lower bracket taxpayer this wouldn't apply).

Anyway, in sum, I think the recommendation they gave you is pretty sensible, depending on what else (if anything) you hold. And remember -- as long as you're avoiding fees and making broad, diversified market investments you'll likely be fine. They key is maxing out your 401(k) and IRA contributions and saving as much as possible on top of it -- if you do that you're way ahead of most Americans.

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