How to pick investments in your 401(k)

Trying to choose the investments in your 401(k) plan is a complicated assignment, one that nearly every working professional is tasked with doing, even though few have been trained to do it.

Smart investors realize they may not have all the knowledge required, want to understand how to make the right choices, and seek to educate themselves on the fundamentals in order to do so.

You have been tasked with this but you haven’t been trained for this — which is understandably frustrating. So, here are the steps I recommend. (This is basically the process I go through when advising a client.)

Find the list of investment choices in your 401(k) plan

401(k) plans offer a limited selection of mutual funds you can invest in. (Some also offer a brokerage window that opens you up to a wider world of funds, but that goes beyond what we’re talking about here.) After helping so many clients locate this complete list on their plan’s website, I’ve learned that finding it is sometimes easier said than done.

It’s usually easy to find your statement that shows you the funds you are already invested in. That’s not what you need. You want to see everything that’s available to you, whether you already own it or not. It might be called “Investment Options” and might be inside an “Enrollment Guide” or “Plan Document.” Sometimes it’s included in the larger company “Benefits Guide.”

Figure out what fees each mutual fund charges

Every mutual fund charges fees to run the fund, typically for administrative and management expenses. It’s known as an expense ratio and is expressed as a percentage. The thing to know here is that there’s huge variation from one fund to another. Generally, you want to pay as little as possible.

Let’s say Fund A has an expense ratio of 1.50% and Fund B has an expense ratio of 0.05%. If you have $100,000 invested, you’re paying $1,500/year to Fund A versus just $50/year to Fund B. That is a very, very significant difference that makes an enormous impact on the long-term growth of your money.

So, the first thing to do to cull the list of investment options in your plan is to find and compare the expense ratio for every fund. (This may also require some digging.) In my opinion, anything above 1.00% is a non-starter. If your plan offers index funds and other passive investments, you may find expense ratios below 0.20%. Here at Pearl Financial Planning, we believe passive investing is what’s best for almost everyone.

Determine your asset allocation

When you have your winnowed-down list of funds with acceptable expenses, you need to start thinking about which ones are appropriate for you and how to combine them. This is where things get a little trickier.

What we’re talking about here is asset allocation: the mix of stock funds and bond funds that’s right for you. Getting this balance right is the most important decision you will make regarding your investments. (This and a good dose of optimism will take you far.)

At a very high level, stocks are what bring the returns (because they carry more risk) while bonds “smooth the ride” so you can sleep at night (because they carry less risk). Dialing in this ratio for an individual is science and art. You need to take enough risk to grow your wealth to fully fund your 30-year retirement, while also considering your personal tolerance for watching your account balance go up and down over time.

Most of my clients are mid-career professionals in their 40s, and after completing a risk assessment, we often target an asset allocation of 80% stock funds and 20% bond funds. But every individual and couple has a unique situation so you need to figure out what’s right for you. If your 401(k) plan website offers tools to help you determine your asset allocation, take advantage of those.

Make sure you have adequate diversification

Once you’ve figured out what portion of your account should be in stocks, diversification means spreading those dollars across a variety of asset classes: large companies and small companies, growth and value, US and international, developed countries and developing nations.

Why is diversification important? We can’t know what will be hot next and which areas will lie dormant for a while. Owning a variety of investments, that often run on different cycles, means you’ll get the blended long-term return. Remember that you’re not trying to beat or outguess the market; your goal is simply to get your fair share of the market’s returns.

Again, you can see that things start to get complex. To keep it very simple, you want to own large and small companies, in the US and international. One thing I see often (that I help people correct) is owning just an S&P 500 index fund, which includes only large US companies. I typically recommend more diversification than that.

Can you use a target-date fund?

Maybe. Many plans offer target-date funds: a single mutual fund that makes all the decisions for you. The fund includes a stock component and a bond component (asset allocation) and considers other factors like country, company size, etc. (diversification). Target-date funds are a one-size-fits-all solution based on one piece of information about you: your retirement year. 

If your plan offers target-date funds, the first thing to look at (again) is the expense ratio

What I tell my clients is: If you’re just getting started and your account balance is small, a target-date fund is probably fine. When the absolute dollar amounts are smaller, you don’t need to worry so much about making the just-right investment decisions. However, when your account gets larger, it’s important to find the right asset allocation and diversification for you, aligned with your specific goals and personal values.

Choose 401(k) investments in the context of your life

Choosing investments in your 401(k) creates a strange mix of emotions. On one hand, you feel like it shouldn’t be that hard. After all, it’s something nearly every professional employee is expected to do for themselves. On the other hand, there actually is a lot to know. How important is it to get it exactly right? That really depends on where you are in your career. If you’re just starting out, pick a low-cost target-date fund, and get back to earning and saving.

However, if you’re a mid-career professional who is starting to build up some real money in your account (such a nice feeling), it’s worth devoting some attention to trying to get it right.

One final point to consider: Your 401(k) at your current company does not exist in a vacuum. If you have a couple of old 401(k)s from past jobs, perhaps an IRA at Vanguard, and maybe some other investment accounts, well, you’ve got yourself an investment portfolio! When you have a portfolio, you really need to consider all of it before you can make good decisions about any of it. 

The truth is, investment decisions are not about your accounts. They are about you. Who you are and what you want. Which is what real financial planning is all about.

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If you want to work with a Financial Life Planner who will help you select 401(k) investments in the context of your larger life, learn more about our services or schedule a complimentary consultation.