My entire 401(k) is invested in one fund

December 21, 2012: 5:06 AM ET
NEW YORK (CNNMoney)

I'm 46 and have my entire 401(k) invested in a Standard & Poor's 500 index fund. Is this a good choice? -- E.M., Phoenix, Ariz.

If you don't mind having your retirement security riding solely on the performance of large company domestic stocks, then I suppose one could say you've made an excellent choice.

But I wouldn't say that.

Granted, by choosing an index fund, you're at least enjoying the benefit of low annual costs. But by limiting yourself to only one asset class -- stocks -- and then further restricting your options by excluding small companies and foreign firms, you're missing out on the benefits of broad diversification.

As a practical matter, that means your portfolio will likely be more volatile than it would be if you spread your money around more.

At the very least, I think you ought to consider adding a dollop of bonds to your portfolio. I realize that many people are jittery about bonds because of fears that interest rates will rise and bond prices will fall. But there are ways to mitigate the impact of rising rates.

Besides, whatever risks there may be in bonds, they pale in comparison to the setbacks stocks periodically sustain. So adding bonds to your portfolio will add some ballast that will come in handy the next time the stock market sinks.

Related: Index funds: A simpler, cheaper way to invest

Beyond bonds, I'd also recommend you further diversify your stock exposure by adding some U.S. small-cap stocks. Doing so would not only bring your stock holdings more in line with the makeup of the stock market overall, it would also give you a shot at higher returns. Over long periods, small stocks have generated annualized returns two percentage points or so higher than those of their bigger brethren.

If you stopped there, you'd have a nicely diversified domestic portfolio -- and I think you'd do fine. But you might also consider going for more diversification gusto and branching out into foreign shares.

Foreign stocks: Safe for retirement?

The rationale for taking this step is twofold: First, by not investing internationally, you're ignoring more than half of world stock market capitalization; second, while foreign shares tend to follow U.S. stocks when the market plummets, they don't always move in tandem with the U.S. market. That means that over the long term, adding some foreign shares can dampen the swings in your portfolio's value.

I'm sure others might tout the advantages of throwing even more investments into the mix -- gold, a commodities fund, whatever. But once you have the basics covered, I'd be more inclined to exercise restraint. Otherwise, you could end up with a portfolio that's harder to manage and may not perform better anyway.

Related: Stocks vs. bonds: Finding the right mix

There are a number of ways you can make the transition from your all-S&P 500 portfolio to more balanced one. If your 401(k) offers the equivalent of a total stock market index fund, total bond market index fund and a total international stock index fund, then you can simply liquidate your S&P 500 fund and move the proceeds into those three funds.

Since gains in tax-advantaged accounts like a 401(k) aren't taxed until withdrawal, you don't have to worry about any tax impact of selling your S&P 500 shares.

How you divvy up your money among stocks and bonds depends largely on how much risk you're willing to take. But for someone your age, 70% to 80% in stocks would be a reasonable starting point. If you decide to diversify internationally, then you might devote, say, 20% to 30% of your stock stake to foreign shares.

Chances are, though, that your plan doesn't offer such broad-based funds. In that case, you'll have to do a bit more work, but nothing too difficult. Essentially, you would want to sell off enough of your S&P 500 fund and spread the proceeds among a broadly diversified small-cap fund, international fund and bond fund, so that you end up with something along the lines of 50% in your S&P 500 fund, 10% in small-caps, 15% in foreign shares and the rest in bonds.

Related: Investing in uncertain times

I know that many people would counsel you to make this transition gradually by dollar-cost averaging to your new portfolio over the course of a year or so. But I don't think it makes sense to delay getting to a better-diversified portfolio.

That said, if you find that you just can't emotionally handle doing this all at once, make the move over a period of three months.

Once you've decided how to divvy up your portfolio, make sure that your ongoing contributions and, to the extent possible, any company matches are invested to reflect your portfolio's new composition, and then rebalance annually (or use your plan's automatic rebalancing feature if it has one) to maintain your allocation targets.

If you find this sort of rejiggering requires too much effort, you can always invest in a target-date fund, asset-allocation fund or, for that matter, a balanced fund, assuming your plan offers such funds.

But I strongly recommend you go with one of the options I've outlined. Otherwise, you'll unnecessarily take on more risk by pegging your retirement prospects to a single sector of the global financial markets.

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