How to Choose the Funds in My 401(k)

Take a walk with June down the 401(k) path to find out how to choose the best funds for your retirement account. June is a 27-year-old employee at a startup with a 401(k) plan. She’s committed to saving for retirement and is contributing 10% of her paycheck into the 401(k) account. There are multiple funds from which to choose. But, June is paralyzed by choice. She doesn’t know anything about investing and is confused about where to begin. This article will walk June down a wise investing path and help her choose the right investment funds in her 401(k). You can use this same process to choose the best funds in your 401(k) account.

Step 1: Know yourself and your time horizon

Just like most things in life, there’s no one-size-fits-all investment plan. Some investors panic if their investment values go down 5%, while others can handle a 25% annual drop and remain cool. Before June tackles the task of choosing a fund, she needs to do a gut check. There are many ‘risk quizzes’ online, and her 401(k) provider might even offer one. A risk quiz questionnaire helps you figure out how much volatility you can tolerate in your investments.

The results of June’s risk quiz suggest that she’s a moderately aggressive investor. June expects to retire in approximately 40 years at age 67. With many years until she withdraws her retirement funds, June is confident that she won’t bail from her investments even if they drop in value 15% to 20% one year.

This risk profile will inform her asset allocation or the percent of stock funds vs bond funds and fixed investments. The outcome of the June’s quiz suggests that an 80% stock and 20% bond allocation is reasonable for now.

Step 2: Understand investing basics and what the fund names mean

Before June chooses from among the list of 401(k) investment choices, she needs to gain some investing knowledge. Again, her employer website may have articles and tutorials about basic investing principles. If so, she’s in luck. If not, then she’ll need to learn the investing basics on her own.

In general, a few basic investing ideas will set her up for the next step. June begins her investing basics study by learning about the common types of funds. Employers typically offer several varieties of investment products:

• Fixed funds

• Cash funds

• Stock funds

• Bond funds

• Combination funds

• Target-date funds

To understand the investments, here’s a quick tutorial about the assets within each of these fund categories and their specific characteristics.

Fixed and cash funds typically are very low risk. Their principal value is constant and their interest rate or returns are generally low. In today’s market investors can expect annual returns from 0.75% to 3.0% in a cash or fixed fund.

Stock funds are baskets of partial ownership in publicly traded companies. Stock funds come in many varieties; international, U.S., actively managed, index, high-dividend, and more. In general, stock funds earn average annual returns in the 7%-9% range, but the returns are volatile. It’s not uncommon for a stock fund to lose 25% or more one year or gain that much in another. Here’s a chart showing recent S&P 500 (a total stock market proxy) annual stock market returns.

Source: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html

In spite of the volatility in annual returns, the average annual stock market return of the S&P 500 from 2006 through 2015 is 7.25%. To sum it up, stock funds historically offer higher average annual returns along with greater ups and downs in their value.

Bond funds are comprised of a mixture of various types of bonds. A bond is a loan to a government, municipality, or company whereby the lender or investor receives a dividend or coupon payment. Like stock funds, bond funds come in many varieties from corporate, government, international to a mixture of various types of bonds. Bond fund returns are typically lower than those of stock funds with less volatility as well.

Combination funds include a mixture of stocks and bonds.

Target date funds are popular in 401(k) accounts. These types of combination funds are one-stop shopping for the consumer. They contain a combination of stocks and bonds and vary their asset allocation over time. They have an end date, to correspond with the investor's expected retirement date. If June were to choose she might pick a Target Date, 2055 fund, to approximate her retirement date. The funds begin heavily weighted towards riskier, higher return stock funds and as retirement approaches, gradually shift to a greater weighting in bond funds.

More information: Target Date Funds in 401(k) Plans: Good or Bad Idea?

Within each of these broad categories, there are actively managed funds and passively managed index funds. In actively managed funds, the fund manager(s) buy and sell securities and attempt to garner the best returns for the investor. Passive index funds follow pre-determined stock and bond indexes such as the S&P 500 in order to match their investment returns.

June now grasps her asset allocation and a few basics about investing characteristics. Next, she needs to understand what’s available in her 401(k) plan.

Step 3: Know your plan and your options

With the heavy lifting complete, June is ready to choose her funds. She understands her asset allocation of 80% stock funds and 20% bond funds. She wants some diversification beyond the U.S. and wants to keep her investing low cost and simple. You may prefer a greater number of funds in your 401(k) for broader diversification. With the diversification decision, there’s no right or wrong answer.

Here’s a sample of the fund choices in her 401(k) account:

Cash

FDIC Insured Deposit Account

Source: https://humaninterest.com/investments/

June is pleased to find out that all of the funds offered by her plan carry low management fees-below: 0.20%. This means that whichever funds she chooses, more of her money will go towards the actual investments, not to the fund managers' pockets.

Next, June must decide whether to choose several funds from each category to populate her 401(k) or to keep it simple and just select one from each category. To help with her decision, she visits the Vanguard website to read about the returns and risks of each of the investment funds.

If your 401(k) lacks low fee, index funds, you might research the individual fund offerings more thoroughly. A default choice is to go with a target-date fund.

Step 4: Choose Your Funds

Armed with basic investing education and a list of the fund offerings in your plan, you’re ready to choose your funds. This is not a final decision, as most plans allow you to amend your fund choices. June prefers broad diversification, with few funds.

June decided to invest this way:

65%-Vanguard Total Stock Market Index Admiral (VTASX)-0.05% fee

15%-Vanguard Total International Stock Index Admiral (VTIAX)- 0.14% fee

20%-Vanguard Total Bond Market Index Admiral (VBTLX)-0.08% fee

June’s investment portfolio is broadly diversified across the U.S. and internationally with stock mutual funds and diversified across the U.S. with bond funds. Her 80% stock-20% bond investments are covered with just three mutual funds.

Is this the appropriate asset allocation or fund choice for you? Not necessarily! See: How and Why to Change Your 401(k) Setup Percentages.

If you prefer more diversification, you might want to add a real estate investment trust fund (REIT), a small or mid-cap stock fund, and other varieties of bond funds. Once you’ve decided on your asset allocation, you can elect to fill the stock and bond categories with the funds you prefer. There’s no ‘perfect’ investment portfolio, as various categories of investments will increase or decrease in value according to their own schedule over the long haul.

For the ambitious investor, you may want to learn more about basic investing. For the rest, a simple, passive, investment plan will likely yield market matching results:

Geometric Average Returns

Source: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html

As the above chart shows, the long term, market-matching results are in the 7-9% range for stocks, 4.5-6% range for bonds and from 1-5% for cash. Although, past returns don’t predict those of the future.

Step 5: Review annually

Choosing the best funds for your 401(k) is a fluid process. At the end of the year, your portfolio allocation will shift from your preferred one and you may want to sell some of the better performing funds and buy the laggards. You may decide to add or replace a fund. In the final analysis, choosing the best funds for your 401(k) is an ongoing process. Make your best decision for today and if necessary, adjust over time.

Related article: Socially Responsible Investing: A Beginner's Guide to Choosing Ethical Funds Image credit: Olu Eletu