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This question has quite a few parts but answers to any part is certainly welcome : )

I'm having trouble finding an answer to what I think should be a simple question. When I see my 401k is up 10% for the year, what does that mean? Is that return used to buy more shares? If so, how often does that occur? Is this what rebalancing does, or are they totally different concepts? If additional shares are not repurchased on a weekly/monthly basis, and I am only part of the way through the year, but up 15%, should I sell now and leave find different funds to invest in for a while?

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I'm not sure what it is that you're asking... Calculation of ROI for 401k is no different than any other investment account. What is unclear to you? –  littleadv Sep 8 '12 at 0:33
    
what is happening to the profits ... if I'm up 10% on a stock, at some point I would sell it and reinvest on something new. Or if I was getting 10% in just dividends, I may revinvest with the 'cash' ... I guess what I'm getting at, if part of my 401k is earning dividends, what is happening with that cash –  pyInTheSky Sep 8 '12 at 0:38
    
Whatever you instructed your custodian to do with it. Who knows? Check your account. –  littleadv Sep 8 '12 at 0:43

2 Answers 2

Your employer sends the money that you choose to contribute, plus employer match if any, to the administrator of the 401k plan who invests the money as you have directed, choosing between the alternatives offered by the administrator. Typically, the alternatives are several different mutual funds with different investment styles, e.g. a S&P 500 index fund, a bond fund, a money-market fund, etc. Now, a statement such as "I see my 401k is up 10%" is meaningless unless you tell us how you are making the comparison. For example, if you have just started employment and $200 goes into your 401k each month and is invested in a money-market fund (these are paying close to 0% interest these days), then your 11th contribution increases your 401k from $2000 to $2200 and your 401k is "up 10%".

More generally, suppose for simplicity that all the 401k investment is in just one (stock) mutual fund and that you own 100 shares of the fund as of right now. Suppose also that your next contribution will not occur for three weeks when you get your next paycheck, at which time additional shares of the mutual fund will be purchased Now, the value of the mutual fund shares (often referred to as net asset value or NAV) fluctuates as stock prices rise and fall, and so the

401k balance = number of shares times NAV

changes in accordance with these fluctuations. So, if the NAV increases by 10% in the next two weeks, your 401k balance will have increased by 10%. But you still own only 100 shares of the mutual fund. You cannot use the 10% increase in value to buy more shares in the mutual fund because there is no money to pay for the additional shares you wish to purchase. Notice that there is no point selling some of the shares (at the 10% higher NAV) to get cash because you will be purchasing shares at the higher NAV too. You could, of course, sell shares of the stock mutual fund at the higher NAV and buy shares of some other fund available to you in the 401k plan. One advantage of doing this inside the 401k plan is that you don't have to pay taxes (now) on the 10% gain that you have made on the sale. Outside tax-deferred plans such as 401k and IRA plans, such gains would be taxable in the year of the sale. But note that selling the shares of the stock fund and buying something else indicates that you believe that the NAV of your stock mutual fund is unlikely to increase any further in the near future.

A third possibility for your 401k being up by 10% is that the mutual fund paid a dividend or made a capital gains distribution in the two week period that we are discussing. The NAV falls when such events occur, but if you have chosen to reinvest the dividends and capital gains, then the number of shares that you own goes up. With the same example as before, the NAV goes up 10% in two weeks at which time a capital gains distribution occurs, and so the NAV falls back to where it was before. So, before the capital gains distribution, you owned 100 shares at $10 NAV which went up to $11 NAV (10% increase in NAV) for a net increase in 401k balance from $1000 to $1100. The mutual fund distributes capital gains in the amount of $1 per share sending the NAV back to $10, but you take the $100 distribution and plow it back into the mutual fund, purchasing 10 shares at the new $10 NAV. So now you own 110 shares at $10 NAV (no net change in price in two weeks) but your 401k balance is $1100, same as it was before the capital gains distribution and you are up 10%. Or, you could have chosen to invest the distributions into, say, a bond fund available in your 401k plan and still be up 10%, with no change in your stock fund holding, but a new investment of $100 in a bond fund.

So, being up 10% can mean different things and does not necessarily mean that the "return" can be used to buy more shares.

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A 401(k) is an investment just like any other investment. You generally get two types of return lumped into that number, but there can be more and you should read your funds prospectus carefully.

  1. "Paper Profits": This is the return your account has gained due to the increase in the value of your holdings. For instance, owning a few shares in AAPL that were purchased @$100/share and are now trading for $680.44/share. In the case of paper profits you don't have a real return or "profit" until the shares are sold. Redistribution is one way of forcing you to turn paper profits into real profits (by selling the shares and reinvesting them in another less risky vehicle), but not the only way (you could just sell and hold the cash, among other things).
  2. Dividend income: This is the money paid to you by various companies that you have invested into. This can be reinvested into the same company, new companies, or held as cash. It is a "real" return as it is in cash and doesn't have to be sold to be gained.

If you aren't investing in direct companies, you're using mutual funds for instance, then you should read the funds prospectus to see how they handle these situations for the underlying securities they hold for you. Although I think this is the basic answer to the question as you asked.

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