So you start your 401k plan with your employer – now what? One of the first things to happen is that you probably receive a packet of all the different 401k investment options for you to choose from. What does all of it mean? If you’re new to investing or not sure what to do, how can we make sense of all the choices and know what the right ones are to pick?
This post will attempt to steer you in the right direction and simplify things so that you can make some generally good decisions.
Types of Investment Options:
First things first, 401k plans are generally setup with a large and reputable financial institution, so the types of offering they have will be similar in nature to ones you could buy on your own if you were a private investor. Depending on what type of arrangement your employer set up, your plan may offer some palette of mutual funds, stocks, ETF’s, etc.
The majority of most 401k investment options are mutual funds. If you’re unfamiliar with what a mutual fund is really, it is just simply a collection of different investment types all rolled into one package. For example, you might buy a share of a mutual fund that is made up of several other different types of stocks, bonds, ETF’s, cash, and other holdings.
This is a big convenience to you because it would be quite a daunting task to try to buy and track the performance of all of these different types of assets all by yourself.
The other great thing is that you can easily switch around the number of shares you own without a lot of complication, fees, or tax consequences.
Most mutual funds concentrate on one specific type of asset class or type of holdings. Look at the description of your investment option and you might see the following:
- Cash (money market)
- Government bonds
- Corporate bonds
- Foreign bonds
- Large cap value stocks
- Small to medium cap growth stocks
- Foreign stocks
- Precious metals
- Real estate
We could literally spend an entire post talking about each one of these specific asset classes, what the risks and potential returns are, and what that would mean for your portfolio. But the goal of this post is to give you an overview and break things down as simply as possible. So just remember this:
- Starting from top to bottom, each group progressively has the potential to fetch better returns
- Starting from top to bottom, each group progressively has the potential to also be riskier
So what does that mean for you?
- Don’t pick just one type of fund. Mix it up and get some diversity among your assets. Choose some relatively safe funds to protect your money and some relatively riskier ones to grow your money.
How to Evaluate Your 401k Investment Options:
If you’d like some help specifics regarding which metrics to examine more closely when it comes to picking your 401k investment funds, then you may find this post How to Pick Good Mutual Funds for Your 401k or Retirement Plan helpful.
To summarize the criteria, look specifically at:
- What the fund invests in
- How the fund has performed in the past over the long haul
- What the expense ratio is for the fund (how much it will cost you)
Target Date Funds:
One easy way to mix it up: Try going with a Hybrid or Target Date Fund. These are generally some type of all-in-one fund that is pre-designed to bring together a bunch of different asset classes (such as stocks, bonds, real estate, etc).
The goal of these types of funds is often to hit some pre-determined retirement date or provide a certain consistent level of return each year.
Warning: Don’t just automatically pick these funds on name alone. They should be treated just like any other investment other there. Using our criteria above, make sure you look at the performance history, expense ratio, and what types of investments they plan to put your money in. If any of it seems uncomfortable, keep looking.
Stocks and ETF’s:
Although it’s rare, some 401k plans offer individual stocks and ETF’s.
Stocks can be great investments by themselves, and a lot of people have done really well with them. But they are also extremely risky and require a good strategy for diversification.
Exchange Trade Funds (ETF’s) act a bit more like mutual funds, but they trade the same as stocks. There is a lot of media attention over the low expense costs of these types of funds. However, as far as investments go, they are relatively young and therefore there is not a lot of historical data to support whether or not they are truly better than a mutual fund.
When it comes to these types of funds, my suggestion is that you should never invest in anything 1) that you don’t understand or 2) don’t feel comfortable with. It’s your money. You decide what works best for you.
If all else fails, almost every 401k investment plan gives the option to go with a low cost stock index fund that replicates the market average. Not only are these funds usually the lowest cost, but there is also a lot of research to suggest that even active funds can’t beat the average returns of an Index Fund.
Therefore, even if you did try to go with a fancier, more expensive mutual fund, you might find in the long run that you had been better off just going with the boring, low cost Index Fund. For the beginner who knows nothing about investing or cares to exert any extra effort in learning about it, the index fund route may not be such a bad strategy.
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