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How to Choose the Right Investments for Your 401(k) Plan Allocation

You’ve just started a new job, and one of the benefits it offers is a 401(k) plan. That’s great news for you since this type of plan is one of the best ways to save for retirement. It’s easy, it offers tax benefits, and your employer will even match a portion of the money you contribute. So signing up for it is a no-brainer.

But after that, you face a much tougher decision: how to invest your contributions.

It’s not that your employer won’t provide any information about your choices. In fact, they’ll provide too much – pages and pages of instructions and advice about things like asset allocation, fund performance, and fees. It’s all too much to take in. All you want is a simple answer: Which funds are best for you?

Answering that question involves three steps. First, learn about the different types of investments you have to choose from. Second, figure out the right mix of investment types that will give you the balance of risk to reward that you want. And finally, choose the specific funds within each category that will offer you the best return.

Types of Investments

When you first sign up for your 401(k), your employer will enroll you in a default set of investments. You can leave your money there or move it into other investments of your choice. According to the Financial Industry Regulatory Authority (FINRA), most plans give you a choice of at least three funds, and some have dozens of options. A typical plan will have between eight and 12 funds to choose from.

While you can choose how to invest your own contributions, only some 401(k) plans let you decide how to invest matching contributions. Others leave this decision up to your employer. For example, some companies automatically give you all matching funds in the form of their own stock.

Here are some of the investments most commonly offered as part of a 401(k).

1. Mutual Funds

The most common type of investment offering for a 401(k) plan is mutual funds. These funds spread their money across a wide variety of investments, which makes them less risky than individual stocks or bonds. Mutual funds can invest in stocks, bonds, or a mixture of the two – an option known as a balanced fund.

Some mutual funds are professionally managed, with experts choosing the specific stocks or bonds to invest in. Others are index funds, which simply put money into every stock in a particular market index, such as the S&P 500. With an index fund, you can’t beat the performance of the index, but you also can’t do any worse. And because these funds charge lower fees than managed funds, you get to keep more of those earnings in your pocket.

2. Company Stock

If you work for a publicly traded company, your 401(k) is likely to offer you the option of putting some of your money into your company’s stock. It gives you a financial stake in the company’s success; if the company is doing well, so will your investment.

Employers often nudge you toward this choice because they think it will strengthen your commitment to the company. For instance, they can:

  • Offer you the stock at a discount
  • Match more of your contribution if you put it into company stock
  • Allow you to invest a larger percentage of your own earnings if you’re buying company stock

However, buying any individual stock is always riskier than investing in a mutual fund, so experts advise against investing a majority of your contributions this way.

3. Individual Securities

According to Forbes, about 40% of all 401(k) plans give you the option of opening a brokerage account, or “brokerage window.” Through it, you can buy individual stocks and bonds just as you would with a taxable account. However, because your 401(k) plan is tax-deferred, you owe no tax on the profits if you sell a security at a profit.

A brokerage window typically comes with an annual fee, and some also charge transaction fees or commissions for each trade you make. In addition, you can pay higher fees for mutual funds you buy through a brokerage window than you would for funds that are offered directly as part of your plan.

4. Variable Annuities

Some 401(k) plans offer variable annuities, a type of investment sold mainly by life insurance companies. When you buy one, your money goes into a variety of mutual funds and grows tax-free until you start withdrawing it. At that point, you are paid a fixed amount every year, which depends on how much you’ve put in and how much your investment has earned.

One perk of variable annuities is that they usually come with a death benefit rider. If you die, your spouse or another beneficiary can still collect on the annuity. This investment can also offer ongoing, lifelong payments. However, variable annuities tend to have much higher fees than mutual funds, and their tax benefits don’t help you when you buy them through a 401(k), which is tax-deferred, anyway.


Allocating Your Assets

Risk Letter Blocks Pulling Pushing

Once you know what investment choices your plan offers, you can start to consider how you want to divide up your money between different types of investments. This depends largely on what kind of balance you want to strike between risk and return – that is, the amount you earn on your investments.

Risk vs. Return

The safest way to invest would be to keep all your money in bank accounts and other low-risk investments. However, if you did this, there’s a good chance your money wouldn’t earn enough interest to keep pace with inflation. That means the actual buying power of your money would shrink – a big problem if you’re relying on that money to get you through retirement.

You can earn more by putting your money into fixed-income investments, such as bonds. These offer a sure, steady return. The only way you can actually lose money on them is if the company you’re borrowing from goes bankrupt.

However, to earn a bigger return, you need to invest in stocks. These are a riskier investment because their value goes up and down over time. However, in the long run, they offer the most significant returns.

In short, there’s no such thing as an investment that’s both perfectly safe and high-earning. Whenever you invest, you have to make a tradeoff between earnings and protecting your money from loss. The key is to find the right balance for you.

Age & Risk

In general, the younger you are, the more risk it makes sense to take with your investments. Because you’re farther away from retirement, you have more time to benefit from the higher long-term growth of stocks. You also have more time to recover if the market dips and your stocks lose value temporarily.

But as you get closer to retirement, it makes sense to move more of your money from stocks into bonds and other safer investments. That way, you don’t risk losing a lot of your money to a big drop in the market right before you need it to retire on. Bonds and annuities can also provide you with a steady source of income during retirement, which stocks can’t do unless they’re dividend-paying stocks.

In the past, many financial experts recommended using the “rule of 100” to figure out how much of your 401(k) portfolio to keep in stocks as opposed to bonds: Simply subtract your age from 100, then put that percentage of your money into stocks. For example, if you’re 35 years old, you would have 65% of your investments in stocks and the other 35% in bonds.

However, with people living longer these days and bonds offering lower returns, most experts now find this rule too conservative. Instead, they suggest subtracting your age from 110 or even 120. Whichever version of the rule you use, you must remember to rebalance your portfolio every year, gradually shifting more of your money out of stocks and into bonds.

An even easier way to account for your age is to invest in a target-date fund, a special type of mutual fund that many 401(k) plans offer. These funds, also known as lifecycle funds, invest in a mixture of stocks, bonds, and cash. They start out investing most heavily in stocks, then gradually shift to lower-risk bonds and cash as you near your target date, or the date you want to retire. This way, your investments shift automatically over time with no effort on your part.

Risk Tolerance

Another factor to consider when deciding how to invest is your risk tolerance, which basically means how willing you are to take risks with your money. Your risk tolerance depends on many factors, including:

  • How far away you are from retirement, as discussed above
  • What other financial assets you have outside of your 401(k)
  • How much you earn now and expect to earn in the future
  • The risk of losing your job
  • What other sources of income you have

One of the most significant factors is your personality and how comfortable you are with risk in general. Ask yourself: If the market took a big dive tomorrow and your investments lost 50% of their value, would you be able to grin and bear it, knowing that you’ll recover from the loss in time? Or would you bail out and sell off all your stocks to avoid further loss, thereby ensuring that you’ll also miss out on big gains as the market recovers?

If you’re the bail-out type, that’s a sign that you need to keep your portfolio on the lower-risk side. It will prevent you from making big mistakes if there’s a market downturn, and it will allow you to sleep easier at night instead of worrying about the possibility of a downturn in the future.

If you’re not sure what your personal risk tolerance is, try taking a risk tolerance quiz such as this one from the University of Missouri. It can tell you how your tolerance for risk compares with the average investor’s.

Diversification

One way to reduce your risk is by diversifying, or spreading your money across a wide range of investments. That way, if one investment falls, you don’t lose everything.

You can diversify your portfolio in several different ways:

  • Stocks vs. Bonds. First, choose a mixture of stocks and bonds that’s based on your risk tolerance. As a rule, when the stock market is flying high, bond returns tend to fall, and vice versa. With a combination of stocks and bonds, you’ll always have some investments that are doing well.
  • Foreign vs. Domestic. Next, split up your stock investments between U.S. and international stocks. That way, if the market falls in one part of the world, you’ll have investments elsewhere to protect you from taking too big a loss. Depending on what funds your 401(k) offers, you may be able to split your bond investments in the same way.
  • Developed vs. Emerging Markets. You can put a share of your foreign stock investments into “emerging markets” in less developed countries. These stocks are riskier than those from developed markets, but they also have the potential for bigger gains.
  • Large vs. Small. Finally, divide up your U.S. stocks into large-cap (the stock of large companies), mid-cap (medium-sized companies), and small-cap (startups and small companies). Smaller-cap stocks are less stable, but they offer more potential for growth.

Within each of these categories, you can diversify still further by investing in index funds. That way, you’re guaranteed to get a wide variety of large-cap stocks, small-cap stocks, and so on. If you choose a managed mutual fund, there’s a greater chance it will focus heavily on the stocks of a few successful companies.

Finally, avoid investing too heavily in your own company’s stock. Don’t make the same mistake as employees of Enron, who had an average of 58% of their 401(k) assets in Enron stock, according to FINRA. When the company collapsed in 2001, its stock lost 99% of its value, and its employees’ retirement funds dropped right along with it. To avoid a disaster like this, most financial experts recommend keeping no more than 10% of your 401(k) in company stock.


Choosing Specific Funds

Asset Allocation Stocks Bonds Real Estate Commodities

Now that you’ve figured out the big picture – how to divvy up your 401(k) assets among different types of investments – it’s time to decide which specific funds to put your money into within each category. Your goal is to get the best long-term return on the money you’re putting into your plan. To figure out which funds will give you that, you need to look at two factors: performance and fees.

Performance

Now’s the time to go back to that big pile of material your company gave you about its 401(k) plan. There should be a prospectus for each fund the plan offers containing details about its performance over several different periods. Of course, these summaries always come with some sort of disclaimer saying “Past performance is not a guarantee of future results,” and that’s perfectly true. Still, how a fund has performed in the past is the best clue you have for how it’s likely to perform in the future.

Typically, the info sheet for each fund will list its average annual return for the past quarter, year, three years, five years, and 10 years – or, if the fund isn’t 10 years old yet, since it started. For you, the most useful of these numbers is the 10-year return. After all, your 401(k) is a long-term investment. You’re buying these funds to hold them until retirement, not to sell them and make a quick profit. You want funds that can offer solid, long-term growth, and the long-term return is the best way to judge that.

Fees

Another thing to look at on each fund’s information sheet is its expense ratio. It’s the percentage of the money you invest that you’ll spend on 401(k) fees. For example, if the expense ratio for a particular fund is 0.80%, that means $8 out of every $1,000 you invest will go toward fees, cutting into the return you earn on your investments.

Even a small difference in the expense ratio can add up to a big difference in your long-term earnings. For example, say you’re investing $6,000 per year in a fund that’s earning a 7% annual return. If that fund has an expense ratio of 0.40%, then over the next 30 years, it will cost you $45,527 in fees. But if you invested the same amount in a fund with an expense ratio of 0.80%, you’d pay $87,300 in fees – a difference of more than $40,000.

Fortunately, the prospectus for a mutual fund will typically list its returns “net of fees.” In other words, if the fund claims to have a 10-year annual return of 7%, that’s the amount you’ll pocket after any fees have been taken out. So you shouldn’t need to factor in the cost of fees yourself when you’re comparing two funds.

Still, if two funds appear roughly equal in other ways, it makes sense to go for the one with the lower expense ratio. A fund that’s earning a 9% return and charging 2% in fees will have the same net return as one that’s earning a 7.5% return and charging only 0.5% in fees – for now. But if that first fund’s performance starts to lag a bit, you’ll still be stuck paying that 2% fee, and your earnings will suffer.


Getting Professional Help

Financial Advisor Meeting Couple Clients Advising

If all of this sounds too complicated for you to handle, consider calling in some outside help. There are several ways to do this, including target-date funds, robo-advisors, and professional advisors. All these options will cost you a bit more than choosing your investments on your own, but they’ll also take the work and stress of managing your portfolio out of your hands.

Target-Date Funds

As noted above, these funds automatically diversify your investments and adjust your risk level based on your age. If you put all your 401(k) contributions into a target-date fund and take no further action, you don’t need to worry about following the market or adjusting your investments over time.

The downside is that you’ll pay somewhat higher fees for these funds than you would for other mutual funds. So before choosing one of these funds, check to see how high its fees are and how they will affect your return.

Robo-Advisors

Another way to handle your 401(k) portfolio is through a robo-advisor. These are computer algorithms that set your asset allocation and choose investments for you based on your age, goals, and risk tolerance. They automatically rebalance your portfolio every year to keep it in line with your goals.

Most robo-advisors deal chiefly with taxable accounts, or IRAs. However, there’s one service, Blooom, that focuses specifically on 401(k) investments. Just link your existing 401(k) to Blooom and answer a few questions, and it will identify the funds that are best for you.

It costs nothing to link your 401(k) to Bloom and get a five-minute analysis of your investments. It will show you what you’ve invested in and what fees you’re paying and offer some advice about investment allocation. For a flat $120 per year, you can have Blooom handle your entire 401(k) for you, selecting funds, minimizing fees, and adjusting your portfolio as needed. The service also gives you access to human financial advisors who can help you with any questions you have, even about topics other than your 401(k).

Human Advisors

Paying a human financial advisor to manage your 401(k) is the priciest option. Investment advisors typically charge an annual fee that’s anywhere from 0.5% to 2.5% of all the assets they’re managing for you.

However, having a one-time meeting with a financial planner is a less costly alternative – between $400 and $600 for one to two hours. The advisor can look over your investments, discuss your goals, and recommend the right mixture of investments to meet them. This can get you started with your 401(k) investments, and you can carry on from there on your own or with the help of a robo-advisor.

Pro Tip: If you need help finding a financial advisor, you can use a free service from SmartAsset. It asks you a few questions and then shows you several reputable advisors in your area.


Final Word

Once you’ve selected the investments you want for your 401(k), keep an eye on them. Just because the funds you picked were the best performers this year doesn’t mean they’ll still be the best a year, five years, or 10 years from now. So take the time to look over your quarterly 401(k) statements and see how your investments are doing, and if you’re not happy, don’t hesitate to switch things up.

Being in control of your investments is one of the biggest perks of a 401(k) plan as opposed to an old-fashioned pension plan. Yes, it means more work for you since you have to choose the funds you want and rebalance your portfolio each year. But it also guarantees that you can invest your own money in a way that’s right for you, not the way your employer chooses.

How are your 401(k) funds invested? What strategy did you use to choose those investments?

Amy Livingston
Amy Livingston is a freelance writer who can actually answer yes to the question, "And from that you make a living?" She has written about personal finance and shopping strategies for a variety of publications, including ConsumerSearch.com, ShopSmart.com, and the Dollar Stretcher newsletter. She also maintains a personal blog, Ecofrugal Living, on ways to save money and live green at the same time.

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