How to invest your 401(k)

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: I've got many investing options in my 401(k) -- small caps, large stocks, emerging markets, fixed-income, etc. What would be the ideal portfolio for me considering that I'm 51 and plan to retire at 65? --D.D., Anaheim, Calif.

Answer: While it may be theoretically possible to create an ideal investment portfolio, it ain't gonna happen in the real world.

More than 50 years ago, Nobel Laureate economist Harry Markowitz created a technique known as mean-variance optimization, which investing firms use today to create "optimizer" software designed to pick your ideal portfolio. You get a combination of investments that will generate the best possible return for whatever level of volatility you're willing to accept.

But the problem is that the portfolio you get is designed to excel under a very specific scenario -- the exact volatility, correlations and returns you stipulate. If your predictions about those things don't pan out -- which is invariably the case -- the portfolio's performance may not only be less than optimal, but downright abysmal. It's sort of like designing a bike to maximize performance in the Tour de France but then finding out the race will be held not on paved roads, but on a rutted dirt track.

So if the ideal portfolio isn't achievable, I'd say you should aim to create a reasonable portfolio, or one that has a decent chance of delivering solid returns under a variety conditions.

Clearly, what's reasonable will vary depending on your financial situation, how comfortable you are with seeing the value of your 401(k) account dip when the market goes down and how willing you are to possibly fall short of having a large enough nest egg.

So I can't just tell you how to divvy up your money among the various options in your plan. But I can recommend a process that you can go through so that you end up with a portfolio that should work reasonably well for you.

Stocks vs. bonds

Start by coming up with an overall mix of stocks and bonds that appears appropriate for you. You've got a pretty long investing time horizon -- 14 more years until you retire, plus another 20 to 30 in retirement. So you need capital growth to build the value of your 401(k) between now and retirement and to help maintain purchasing power during retirement. That argues for putting a sizeable percentage of your 401(k) in stocks since over very long periods stocks generally outperform bonds.

That said, we also know that stocks can get whacked for losses of 30% or more occasionally. And at your age you can't afford to lose too big a chunk of your 401(k) balance. You may not have enough time to recoup the loss. So that argues for not going overboard with stocks.

There's no single correct mix for 51-year-olds (or anyone else). But I'd say a blend of 65% to 70% stocks and 30% to 35% bonds is a sensible range for someone your age. You could scale back your stock holdings from that level if you want to play it safer heading into retirement. Or you could bump up your stock holdings a bit if you're comfortable about taking on more risk for the possibility of more gains. Whatever mix you settle on, you would gradually shift it more toward bonds as you age.

What type of stocks?

If you could foretell the returns of, say, large-cap, small-cap and foreign stocks as well as how they'll move around compared with each other, you could put together an ideal blend.

But you can't. Which is why for the domestic stock holdings in your portfolio, I think you should take your cues from the way investors overall divvy up their money between different types of stocks. To do that, plug the ticker symbol (VTSMX) for Vanguard Total Stock Market Index fund (VTSMX), which tracks the entire U.S. stock market, into Morningstar's Instant X-Ray tool. You'll immediately see how U.S. stock investors allocate their investing dollars by stock size (small, medium and large) and style (value, growth and blend). Unless you think you know something your fellow investors don't, I wouldn't stray too far from those allocations.

It's not a bad idea to diversify your portfolio a bit more by adding some foreign stocks, assuming they're available in your plan. How much foreign exposure? I'd say 10% to 20% of your overall stock holdings in broadly diversified foreign funds ought to do it.

You could also consider branching out into emerging market foreign funds. But don't be unduly swayed by their recent boffo returns. These funds are the investing world's versions of manic depressives, flying high one year, crashing the next. So if you dabble in them at all, they should represent only a small portion of your foreign holdings.

What type of bonds?

Again, I think broad diversification is the key. I recommend that investors consider making a total bond market index fund the core of their bond portfolio. If you want to diversify beyond that into foreign bonds, high-yield and TIPs for a bit of inflation protection, fine. But these options combined probably shouldn't account for more than 10% to 20% of your bond portfolio.

When you've got a lot of investment options, there's an inclination to think you should be using as many as you can. Problem is, the more investments you own, the more complicated it gets to choose, monitor and maintain them in a coherent portfolio.

How many funds do I need?

So I think you're generally better off keeping things simple. To my mind, there's a lot to be said for a portfolio of just three funds -- a total U.S. stock market index fund, a total U.S. bond market index fund and a broadly diversified foreign stock index fund -- that you rebalance periodically. That combo would give you large and small shares, growth and value and international exposure.

You can get fancier and add more types of funds. But before you do, be sure you're adding them as part of a long-term strategy that you've carefully considered, not just because a particular fund or asset class is the talk of the TV investment shows.

And if you end up deciding that you're not really comfortable putting together your own portfolio, ideal or otherwise, you might consider a target-date retirement fund, which divvies up your assets for you based on your projected retirement date. Be careful, though. Not all target-date funds are the same. So make sure you know how the fund allocates its assets today and that you understand the fund's "glide path," or how that allocation changes over time.

Bottom line: The process I've outlined won't lead you to an ideal portfolio. But if you follow it and apply some common sense, you should be able to come away with a portfolio that can get the job done.