A byproduct of being a financial advisor is the random financial advice texts from friends and family. One of the most common by far is, “What should I pick in my 401k?”.
While I try to be as helpful as possible, I can usually only answer with, “It depends…”.
Without knowing the fund offerings of the 401k plan, your investments outside of the 401k, your goals, and your risk tolerance, there is practically no way to say which investment options to choose.
Having said that, there are general tips that anyone can apply when making decisions related to a 401k.
Before we get to that though, I think it’s important to understand the basics of investing.
Back to the Basics
There are three basic choices when it comes to investing:
- Cash or investments that can be turned into cash quickly. Sometimes also called capital preservation.
- Bonds, which is essentially you loaning money to a government or corporation in return for a fixed payment back.
- Stocks, which is a share of ownership in a corporation.
Historically, capital preservation and bonds are less risky than stocks but have a lower potential for return.
You’ll probably notice there aren’t any individual bonds or stocks listed as investment options in your fund line up. That’s because it’s hard for the average investor to purchase enough individual stocks and bonds to create a portfolio that is varied enough. So instead, you have a variety of mutual funds or exchange-traded funds (ETFs) to choose from.
Mutual Funds and ETFs. What are those?
Both mutual funds and ETFs are pools of money that are managed by a professional money manager and have a stated objective, such as investing in only Large U.S. tech companies or tracking an index.
The biggest advantage of mutual funds and ETFs is the instant diversification it can give you. That’s because the money manager is able to pool your money with thousands of other investors and purchase a mix of individual stocks and bonds that you wouldn’t have been able to otherwise.
Diversifying helps reduce your overall risk. Think about what your parents used to tell you, “don’t put all of your eggs in one basket!”. With mutual funds and ETFs
Just because you diversify doesn’t mean you don’t run the risk of losing money. The markets fluctuate up and down, and sometimes, they come down a lot. But that’s okay because contributions will be going into the account on a regular basis.
Having money going into your account every month enables you to build significant wealth. That’s because if the price of the investment drops, you are buying it at a discount. We all like buying things at discounts!
so… What Should I Choose?
Luckily, a majority of the hard work has already been done for you. Through a rigorous screening process, an investment fiduciary has pre-selected which mutual funds and ETFs are available to choose from. This is commonly known as the fund lineup.
TIP 1: Everyone is different when it comes to how they want to invest their retirement plan account, and before you make any decisions, I recommend filling out a risk profile questionnaire. This will give you an idea of what type of asset allocation fits your proximity to retirement and your willingness/ability to take risks.
Asset Allocation Matters
Asset allocation simply explains the mix of stocks, bonds, and cash in which you decide to invest. Broadly speaking, the younger you are the larger the share of stocks you should have in your 401k. As you approach retirement there should be a more balanced mix between stocks and bonds as you switch from solely focusing on growing your money to also caring about preserving it.
It’s common to see funds within your 401k plan that basically use autopilot to shift your asset allocation from stocks to bonds as you get older. These are known as Target Date Funds (lifecycle, target retirement) and you’ll usually see a naming convention like Target Date 2045. The year being your goal retirement date.
TIP 2: A mistake I often see is someone choosing a target-date fund but then also having other mutual funds selected that are being invested in the same manner. This means they are doubling their exposure to that asset class and paying twice the fees for no benefit at all! Stick with either a mix of stock and bond mutual funds that meet your asset allocation goals or go with a corresponding target-date fund, but not both.
keep fees in mind
TIP 3: No matter what investment options you go with, always keep fees in mind. They are usually referred to as the “expense ratio”.
The fees on the various funds can vary significantly too. According to the Investment Company Institute, in 2019, the average expense ratio of actively managed equity mutual funds was 0.74% compared to passive stock mutual fund expense ratios of 0.07%. This means that the bill on the $100,000 invested in your 401k could be $740 or $7 a year. Assuming 5% growth per year on that $100,000 for the next 20 years – the 0.74% fund would have a cost of $33,500.
There are very few factors under your control when it comes to future investment results, but one that you do control are the fees you pay.