More and more employer sponsored 401(k) retirement plans are offering a self-directed option. Between 2007 and 2011 the percentage of plans offering this option jumped from 18% to 29%. A self directed 401(k) account allows you to invest in stocks and ETFs, which means your account can be better tailored to your own needs. However this is not the right option for everyone. The purpose of this guide is to help you decide if its right for you, and where to get started.
Drawbacks of a self directed 401(k)
There is a long list of pros and cons to a self-directed 401(k) account. A self-directed plan, when managed well, will give you a slightly better return over time. However, if managed badly you could vastly underperform a traditional mutual fund plan. Let’s look at some of the drawbacks to make sure a self-directed plan is right for you.
Time, Discipline and Knowledge
Managing your own plan will take time and commitment. It will also require a certain amount of knowledge, which again will take time to acquire. If you don’t have the time to devote to it, it’s better to go with a standard mutual fund approach.
Some of the biggest mistakes investors make are caused by emotions, in particular, fear and greed. This can cause investors to rush into an expensive market for fear of missing the rally or cause investors to sell their investments at the worst possible time. You will need to have the discipline to avoid making these mistakes.
Being given more choices often causes investors to make too many changes to their portfolio. Every time you make changes, you pay fees, and those fees add up over time. Successful investors are often those that make very few changes to their portfolio over time.
Even though a self-directed account gives you access to thousands of shares, ETFs, and mutual funds, you only need to own a handful.
Traditional 401(k) retirement plans offer investors a choice of mutual funds. Mutual funds allow you to invest an exact dollar amount by buying fractional units. So, if a mutual fund is priced at $78.25 and you invest $1000 you will have 12.779 units.
With stocks and ETFs, you can only buy a nominal number of shares. So if you want to invest $1000 in a share trading at $78.25 you will have to buy 12 or 13 shares, neither of which is equal to exactly $1,000. So, you will need to track your asset allocation to make sure you are not over or under investing in a particular asset class.
Guidelines for Managing your Account
Just because your 401(k) retirement plan is self-directed doesn’t mean you have to do everything yourself. It’s a very good idea to get help from a financial advisor or planner.
Stick to liquid ETFs with low fees and shares with a market capitalization of at least $500 million, if not $1 billion.
Only invest in companies with a proven track record, and positive cash flows. Your retirement savings do not belong in tech startups or biotech companies looking for the next blockbuster drug.
When it comes to ETFs and shares, work out what your actual commission rate is. Discount brokers often charge a flat fee of $5 to $10. That works out to be very cheap on a $10,000 trade but would mean you are paying a commission of 5 to 10% on a $100 trade.
You should never be paying more than 0.2% on a transaction, which at $5 a trade works out to a deal size of $2,500. So if your account is less than $10,000 you should only be investing in broad-based index funds. You should not be investing more than 5% of a portfolio in a single share. That means you shouldn’t be investing in individual share with an account worth less than $2,500 x 20, or $50,000.
Look for investments you plan to hold for at least 3 to 5 years. In the case of ETFs that can mean funds that invest in countries, regions or sectors – but not funds that invest at the industry level or by investment theme. Industries and investment themes tend to blow hot and cold over the long term.
Provided your account is large enough, an ETF rotation strategy is suitable for a portion of your account. In fact, these types of strategies are an ideal supplement to value-oriented mutual funds. Just make sure that the commissions you pay, and the frequency of trading is not generating excessive fees.
A self-directed 401(k) retirement account can be a powerful tool in saving for your retirement. But, if mismanaged it can also turn into a disaster. If you are going to go down this route, make sure you are committed to doing a lot of research and seeking help when you are not sure. It’s also worth benchmarking yourself against the more conventional alternatives to make sure you are actually adding value – and that should be after fees are taken into account.