Which 401k Funds To Invest In – A few weeks ago I talked about why we should invest. Today I want to talk about company-sponsored retirement plans, which is how most people invest. Specifically, how do I choose which mutual funds to invest in?
Investing in your first 401k (or 403b/457 for nonprofits and government) can be overwhelming. Everyone tells you that you should, but no one tells you
Which 401k Funds To Invest In
To do that, you’ve probably read all about “asset allocation” and how “index funds” are the bees knees. Research is a great first step, but for most of us, things are different when you actually have to apply the information in a real situation. Because when you first log into your 401k account to set it up, you’re faced with an alphabet soup like this:
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With often dozens of 401k fund options to choose from, how do you know which one to choose? And if you can’t interpret all the numbers on a chart, how do you know which ones to pay attention to and which ones are just smokescreens?
Once upon a time I was in the same boat as you. I was so excited to participate in my first 401k. Calculating my contribution was easy. But then I had to decide which investment to choose. Armed with something called a “notebook,” a PDF detailing all the available options, I spent hours googling them to figure out which would bring me the most money.
But I’m not going to waste my time sifting through every single option. Now I look for specific features and narrow down my choices through a process of elimination. It takes about 15 minutes in total.
Today I want to walk you through this process using a real world example of real funds that we can control. I won’t explain every single term because I honestly don’t think you need to know all of them to do a good job. At least I didn’t.
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Disclaimer: I am not a financial professional. This post details what factors I personally consider when choosing investment options. Do your research before choosing an investment.
Ninety-nine percent of the time I encourage you to be like my mom. This is the only time I advise you not to do this.
My heart ached when I learned that my mother had invested 100% of her $401,000 in a money market fund for years. That’s right: Zero shares were invested. Someone equally clueless about the job must have ticked that box for him. Money market funds are the most conservative investment fund option and are similar to cash investments in terms of returns. It’s painful to think how that money could have grown.
If you’re investing in a 401k, you’re planning for retirement, which I’m guessing is decades from now. If the market goes down, you have time to recover, so you can take more risk.
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The item marked “current” in the asset class column? I would ignore it or at least not invest a significant portion of my money in it.
You can’t control how well your investments perform, but you can control how much you pay for your investments. Yes, investing costs money. You pay an annual fee, an “expense ratio” based on a percentage of assets. That’s why I ignore stats like past performance and rankings and just focus on the expense ratio column (in green below).
Looking at the chart, paying a fee like 0.84% doesn’t seem like much, and the most expensive option in the example, 1.02%, seems quite reasonable. But fees can make a huge difference in your returns.
Be sure to note the decimals when comparing cost ratios. At a quick glance, 0.7% and 0.07% can easily look the same.
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Let’s compare how these costs can play out over time. If you started with $10,000 and invested $5,000 a year for 30 years at a 6% return, here’s how much each would cost you.
A difference of 0.63% could cost you nearly $50,000 more over a 30-year period. For me, anything over 1% is fine
. Generally, my criteria for funds are those that charge less than 0.5%, but it all depends on the options you have in your 401k plan. If many of them are expensive, you may have a bad 401k plan.
In addition to fee reports, there are other fees you may incur, such as upload fees and redemption fees, but not in this particular example. However, I also avoid them.
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Calculating fees can be tricky, so all of my investment accounts are linked to Personal Capital, which has a great retirement expense analysis tool. Below you can see how much I pay into the fund each year.
And below is another screenshot of my Personal Capital account, where you can see how my annual expenses compare to the benchmark, and how much I’m losing in fees over a longer period of time.
Ignoring the high fee options now leaves us with about 7 funds out of 30 initial funds. There are four in particular that I like, highlighted in green. These are called index funds. Funds are either passively managed or actively managed. Passively managed index funds are not only significantly less expensive, but their performance is more consistent than actively managed funds.
How to determine which fund is the index? They usually have very low fees, less than 0.1% and the fund name contains the word “index”.
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Looking at the asset class and asset class columns, there are now three different types of mutual funds and one bond fund left:
Now you need to allocate percentages to the funds you choose. You can choose a primer or a mixture, as long as everything reaches 100%. How you divide your portfolio is an important part of your strategy and depends on your risk level.
To illustrate, the chart below shows typical returns based on different allocations. On the left is the more conservative 100% short-term investment (what my mom did). With a conservative portfolio, you won’t get really attractive returns. And on the right is a more aggressive portfolio, mostly in domestic stocks and some in foreign stocks. Having 100% of your portfolio in stocks gives you the most potential for growth… but you may not be able to handle the volatility of the stock market.
Returning to our four options and matching categories to the chart, we have two domestic stock indexes, one foreign stock index, and one bond index to combine.
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Note: I’m using the charts as guidelines, not for exact proportions on how to lay out the portfolio.
A common recommendation is to make sure your portfolio includes both stocks and bonds. There are many tests that can help you figure out how to allocate your portfolio, such as this one from CNN, although I think most of them are too conservative.
Since I have several decades before I reach the money, I choose aggressive growth. And since I appreciate simplicity, I’ll just pick a few funds. And this is what I choose:
Most people also add some foreign stocks, but I prefer to use a different investment account for that. For my 401k, I like to keep it pretty simple because the options are limited.
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Choosing your risk allocation can be intimidating. As I mentioned, there are tests like the CNN test I linked above, or you can link your investment accounts to Personal Capital and it can recommend allocations, like below.
By focusing on a few key concepts, investing doesn’t have to be as complicated as it sounds. And if you can figure it out for your 401k, you can figure it out for the investment accounts you open yourself. In summary, some factors should be considered:
Hope this post was helpful! And if you’d like to try the personal capital program I mentioned for free, you can sign up here and we’ll both get a $20 bonus.
There is no right or wrong way to invest, so I am interested in learning about different approaches. What factors do you consider when choosing your 401k investments?
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