Smart (and not so smart) 401(k) moves

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

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NEW YORK (Money) -- Question: Like many people, I've seen the value of my 401(k) drop considerably over the last year. I am invested for the long haul and am willing to ride out my current losses hoping for recovery. But I'm wondering whether I should re-direct my current and future contributions into my 401(k)'s money-market option until the economy settles. Do you think that's a smart move, or should I just continue investing my new contributions into my current fund allocations? --Mike, Baltimore, Maryland

Answer: I know that some people consider what you're contemplating an excellent idea. In addition to your approach of putting new 401(k) contributions into a secure investing option, I've seen others recommend a similar tactic of directing capital gains distributions (if any, in this market) and dividends of stock funds into a money-market fund or other low-volatility investment instead of reinvesting them back into the stock funds themselves.

And both these actions have a certain appeal - you get to feel that you're gaining some additional short-term security while remaining true to your long-term investing strategy.

But while I agree that tactics like these may be emotionally comforting in disturbing times like today, I don't think that it holds up as an investing strategy.

Why? Well, let's say that as a long-term investing strategy you've settled on a 60% stocks/40% bonds allocation in your 401(k). In your estimation, that blend will give you a shot at returns high enough for you to build a decent nest egg, yet also offer reasonable protection from setbacks in the short term.

Once you start directing new contributions into a money-market fund, what you are really doing is creating an overall portfolio mix in your 401(k) that is more conservative than 60/40. Granted, it's not happening all at once; it takes place gradually. The speed at which your stock exposure drops depends on how much you already have invested in stocks and bonds, the size of your contributions to the money-market fund and how the different parts of your portfolio perform.

But make no mistake: you're not sticking to your original strategy. You're steadily moving away from it. Indeed, I think what you're really saying with this maneuver is that you're not very confident about the strategy you now have.

And that's fine. It's okay to reconsider whether you're comfortable with your long-term investing approach. Plenty of people got so caught up in the five-year bull market that preceded this bear that they invested more heavily in stocks than they should have. A recent EBRI report shows that going into 2008 some 40% of 56-to-65-year olds had more than 70% of their 401(k)s invested in equities and nearly 25% had more than 90% in stocks. That's pretty darn aggressive for anyone that close to retirement.

But by taking the action you're considering, I think you may be avoiding confronting the real issue, which is whether you have the right strategy in the first place and should be sticking to it at all.

Now, I'm not suggesting that you (or anyone else) should be changing your long-term strategy just because we're in the midst of a prolonged bear market. If you revamp your portfolio every time the market takes a dive -- or soars to new highs, for that matter -- you don't really have a long-term strategy.

But if you're having second thoughts or are uncomfortable with the way your portfolio is invested, it makes sense to step back and re-evaluate. Maybe you set the strategy in better times and had an unrealistic notion of what sorts of declines in the value of your portfolio you could deal with. Perhaps you don't have as high a tolerance for risk as you thought you had.

Just remember, though, if you let your anxiety about today's conditions push you too far toward the security end of the investment-strategy spectrum, you may end up with a smaller nest egg than you'd like at retirement.

So before you begin plowing your contributions into cash, I recommend that you first re-assess your strategy. You can do that by going to an online tool like our Retirement Planner or T. Rowe Price's Retirement Income Calculator and give yourself a comprehensive retirement check-up.

You can get a sense of the expected annual return and the three-month loss potential for different mixes of stocks, bonds and cash by going to the Asset Allocator tool on T. Rowe's site.

So as I see it, you've got two choices. You can go ahead with your "I'm going to stick with my strategy, but not really" plan and perhaps feel better for now (or at least until the next time you have doubts about your portfolio).

Or you can re-assess your 401(k)'s portfolio mix and, if you decide it's not really right for you, adopt an investing strategy that you can feel comfortable sticking with for the long-term. In which case, I think you'll not only come away feeling better today, but you'll also be better positioned for the future.

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