Probably the most common mistake made by employees is to allocate an equal amount of money to each of the fund choices. Studies have shown that given ten choices, employees tend to put 10% in each choice. Given five choices they put 20% in each choice. However, doing this means that if four of the choices represent one type of asset and the fifth is unique, their so-called balanced asset allocation is actually split 80/20. If the funds happen to be the other way around, then the asset allocation is 20/80.

The equal proportions methodology builds very poor portfolios. You can’t afford to make these types of mistakes with your future livelihood. The only thing worse than the equal proportions strategy is allocating all of your money to just one fund. You need an investment philosophy that integrates all of your asset holdings. Only then can you evaluate which of your company’s fund options are right and determine what percentage to allocate to each.

Many employer sponsored retirement plans are just mediocre. Neither the fund company nor plan provider has much incentive to fill your selections with stellar choices. Plan sponsors have a fiduciary responsibility, but few take that responsibility seriously. Procedures may or may not be in place even to meet minimum guidelines. Still, you should be able to find a few funds worth selecting in order to gain your employer’s match.

Your own company or plan provider usually isn’t the best place to turn for advice. After all, they are the ones that picked the options in the first place. Then, you should get the outside opinion of a professional financial planner on where to invest.

Another common mistake is to invest in whatever funds have done the best over the past 1, 3, or 5-year period. None of these measures is long enough to produce a balanced asset allocation. Every financial disclaimer states that “past performance is no indication of future returns,” and yet, past performance remains the primary selection criteria for many investors. Too many employees pick the asset category that has done the best over the past three years. However, these higher-than-average returns often represent a peak. Going forward, they are the fund choices most likely to under-perform for the next three years.

While three year average returns is a poor way to select a fund, thirty year average returns is a good way to select an asset category for including in your asset allocation. If small cap value is a good asset category to include for the long term, see if your plan includes any small value funds. Then judge them against other outside funds within their asset class and not against other funds within your plan.

You should be looking for funds which are the best funds within their asset class regardless of how well the asset class has done over the short term of just the last few years. Funds that are the best in their category can often be found through index funds that have very low expense ratios.

Remember also that you are looking for a team of funds and not just a few hot shots. Your retirement portfolio consists of more than just your employer’s plan. Even if your employer’s plan only has a couple of good choices, you can use your other investments to create a balanced asset allocation. While the choices in your employer’s plan may be limited, investments in your IRA or taxable account will have an unlimited number of choices from which to craft a balanced allocation.

It is important to start with an overall asset allocation plan and then see what asset classes your employer’s plan offers that would integrate well with your investment philosophy. Since your employer’s plan usually has the most limited number of choices, pick the best it has to offer that fits with in your over all plan.

The original version of this article was published October 15, 2007 under the title “Employee Retirement Options – Part 2.”
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