Smart Strategies For Choosing 401(K) Investment Funds

A 401(k) is a retirement investment account offered by employers, which is tax-advantaged as the money contributed to it each year, typically a percentage of each paycheck, lowers taxable income. There are two types of 401(k)s: a traditional account and a Roth 401(k). The former is more common and allows pre-tax contributions and tax-deferred gains, while the latter involves contributions made with after-tax money but offers tax-free withdrawals in retirement.

When it comes to managing your 401(k) and choosing funds, here are some key considerations:

- Understand your company's matching formula, if applicable, and try to contribute enough to maximise this benefit.

- Determine how much you can contribute based on your income, debt level, financial goals, and risk tolerance.

- Diversify your portfolio by investing in a range of stock and bond funds to minimise risk.

- Consider your time horizon—if you're younger, you may want to take on more risk by investing a larger percentage in stock funds, and gradually shift to more conservative investments as retirement approaches.

- Evaluate the fees associated with different funds and opt for lower-cost options, such as index funds, which tend to have lower expense ratios.

- Consider seeking professional advice or using a robo-advisor or online planning service for guidance.

- Regularly monitor and rebalance your portfolio to maintain your desired asset allocation.

Understand the basics of investing

Understanding the basics of investing is an important step in managing your 401(k) and choosing your funds. Here are some key points to help you get started:

• Educate yourself about investing: Familiarize yourself with basic investment concepts, terms, and strategies. Read through the information provided by your plan, and don't hesitate to look up any unfamiliar terms. This will empower you to make more informed decisions about your 401(k) and effectively manage your investments.
• Understand your risk tolerance: Investing carries inherent risks, and it's crucial to determine how much risk you are comfortable with. Consider your investment horizon and how you would react to market fluctuations. Younger investors with a longer time horizon can typically tolerate more risk, while those closer to retirement may prefer a more conservative approach.
• Know your investment options: 401(k) plans typically offer a range of investment funds, such as stock mutual funds, bond mutual funds, target-date mutual funds, and stable value funds. Understand the characteristics of each type, including their risk profiles and potential returns.
• Evaluate fees and expenses: Pay close attention to the fees associated with different investment options. Expense ratios, for example, represent the ongoing costs of managing a fund and are charged as a percentage of the amount invested. Opting for funds with lower expense ratios can significantly impact your long-term returns.
• Diversify your portfolio: Diversification is a key principle in investing. By spreading your investments across different asset classes, sectors, and geographic regions, you can reduce risk and improve your potential for long-term returns. Diversification helps protect your portfolio from being overly exposed to any single investment or market segment.
• Consider seeking professional advice: If you feel overwhelmed or unsure about managing your 401(k), consider consulting a financial advisor or using a robo-advisor service. They can provide personalized guidance based on your financial goals, risk tolerance, and time horizon.

Learn about asset allocation

Asset allocation is a crucial concept to understand when managing your 401(k) investments. It refers to how your retirement assets are distributed across different investments, such as stocks, bonds, money market, and others. Here are some key considerations regarding asset allocation:

• Long-term investing: Maintain your allocation through both up and down markets. Stocks, or equity mutual funds, are a crucial component of your allocation, even during retirement. Historically, stocks have typically outperformed other investments while staying ahead of inflation.
• Risk tolerance: Understand your tolerance for risk and ensure your allocation aligns with it. Ask yourself if you're comfortable having your retirement funds allocated in a certain way. If not, make adjustments to reduce emotional stress.
• Diversification: Diversifying your portfolio is a fundamental principle of good asset allocation. Spread your assets across different asset classes and investment styles to minimize risk.
• Regular review: Review your asset allocation annually to ensure it aligns with your life circumstances and long-term goals. Even if nothing has changed, rebalancing your portfolio may be necessary to realign it with your allocation objectives.
• Fees and costs: Mutual funds and other 401(k) investment options come with varying costs. High fund costs can impact your long-term earnings, so be sure to consider the fees associated with each investment option.
• Age-based allocation: As a rule of thumb, your allocation between stocks and bonds can be determined by subtracting your age from 110 or 100. The result is the percentage of your portfolio that should be invested in stocks, with the remainder in bonds. For example, if you're 30 years old, you might invest 80% in stocks and 20% in bonds. As you get older, gradually reduce your stock allocation and increase your bond allocation.
• Target-date funds: If making individual asset allocation decisions seems daunting, consider target-date funds. These funds automatically adjust their asset allocation based on your retirement timeline, becoming more conservative as you approach retirement. Many 401(k) plans offer this option.

Weigh up the risks

Weighing up the risks is an important part of managing your 401(k) investments and choosing your funds. Here are some key considerations to help you make informed decisions:

• Risk Tolerance: Assess your risk tolerance by considering how comfortable you are with market fluctuations and potential losses. If you prefer a more stable approach, you may want to opt for conservative or moderate funds. On the other hand, if you're comfortable with higher risk, you might consider aggressive growth funds.
• Age and Time Horizon: Your age plays a crucial role in determining the level of risk you can take. Generally, younger investors can afford to take on more risk as they have a longer time horizon to recover from potential losses. As you get closer to retirement, it's advisable to gradually shift towards more conservative investments.
• Diversification: Diversifying your investments across different asset classes, such as stocks, bonds, and alternative investments, can help mitigate risk. Avoid concentrating your portfolio solely on one type of investment or company stock, as it increases the impact of a downturn in that specific area.
• Fees and Expenses: Be mindful of the fees associated with different investment options. High management fees and sales charges can eat into your returns over time. Opt for funds with lower expense ratios, such as index funds, which tend to have lower fees than actively managed funds.
• Market Volatility: Keep an eye on market trends and volatility. While short-term fluctuations are common, especially in the stock market, be cautious if you're nearing retirement. A significant downturn in the market just before retirement can have a substantial impact on your financial plans.
• Professional Guidance: Consider seeking advice from a financial advisor or a trusted professional. They can provide personalised recommendations based on your risk tolerance, age, and financial goals. Remember to choose advisors who work in your best interest and are not incentivised by selling specific financial products.

Diversify your portfolio

Diversifying your portfolio is a crucial aspect of managing your 401(k) investments. Here are some detailed instructions and considerations to help you diversify your 401(k) portfolio effectively:

Understand the Basics of Diversification

Diversification is a risk management strategy that involves spreading your investments across various asset classes, sectors, and industries. By allocating your funds across different investments, you reduce the risk associated with putting all your eggs in one basket. Diversification helps capture returns from multiple sources while protecting your portfolio from the potential downturn of any single asset class.

Determine Your Risk Tolerance

Before diversifying your 401(k) portfolio, it's essential to assess your risk tolerance. How comfortable are you with taking risks? Are you willing to tolerate significant fluctuations in the value of your investments? Your risk tolerance will guide the types of assets and the level of risk you're willing to accept.

Allocate Across Different Asset Classes

Diversify your 401(k) portfolio by allocating your funds across different asset classes, such as stocks, bonds, commodities, and more. A common strategy is to invest a larger portion of your portfolio in stocks when you're younger and gradually shift towards more conservative assets like bonds as you approach retirement.

Utilize Target Date Funds

Target-date funds are a great option for diversification. These funds automatically adjust their asset allocation based on your selected retirement year. They become more conservative over time, reducing the risk as you get closer to retirement. This is a "set-it-and-forget-it" option that doesn't require active management.

Choose a Balanced Fund Approach

Consider investing in balanced funds, which allocate your contributions across both stocks and bonds. These funds aim for a balanced approach by minimizing the risk of stocks with more conservative bond investments. While they may not rise as quickly during a stock market boom, they also tend to fall less during market downturns.

Explore Model Portfolios

Many 401(k) providers offer model portfolios constructed by skilled investment advisors. These portfolios are typically named based on their risk level, such as conservative, moderate, or aggressive growth. They provide a well-balanced mix of assets suited to your risk tolerance and long-term goals.

Avoid Overconcentration in Company Stock

While investing in your company's stock may seem appealing, it's generally advised not to concentrate your 401(k) portfolio heavily in this area. Investing too much in company stock narrows your diversification and increases the risk of significant losses if the company experiences a bearish run.

Monitor and Rebalance Your Portfolio

Diversification isn't a one-time event. Regularly review your asset allocation and make adjustments as necessary. Over time, different assets will perform differently, causing your original allocation to shift. By periodically rebalancing your portfolio, you can maintain your desired level of diversification and risk.

Remember, diversification is a long-term strategy, and it's important to make decisions that align with your financial goals, risk tolerance, and time horizon. Diversification does not guarantee protection against losses, but it helps mitigate risks and maximize opportunities for growth.

Rebalance your portfolio

Life is full of routine maintenance, and your 401(k) is no different. In the investment world, rebalancing is another term for maintenance. As different assets move up or down in value, they become a smaller or larger percentage of your overall portfolio.

Financial advisors suggest having a specific allocation of stocks and bonds. For example, if you're 40 years old, you might aim for 80% of your money to be in stocks and 20% in bonds. If that allocation gets out of balance, you may need to buy or sell assets to restore the balance.

A target-date fund can be a good option for those who want diversification that automatically rebalances over time, so you can set it and forget it. These funds are designed to evolve as you move closer to retirement. For example, if you're planning to retire in 2035, you would invest in a target-date fund that matures in that year. The fund's managers will continually rebalance the fund to maintain an appropriate allocation as the target date gets closer.

However, target-date funds may not always be the best choice. They use different allocation strategies, which may not align with your goals, and their performance is largely dependent on the fund managers. Fees for these funds can also be high, and novice investors may not understand that they shouldn't mix them with other investments.

If you don't want to use a target-date fund, you can rebalance your portfolio manually. To do this, you'll need to monitor your investments and make changes when certain assets become a larger or smaller percentage of your portfolio than you intended.

For example, if your portfolio contains both large-cap and small-cap stocks, and the small-cap portion starts to grow more quickly than the large-cap portion, you may need to sell some of your small-cap holdings and reinvest the proceeds in large-cap stocks to restore the balance.

While it may seem counterintuitive to sell your best-performing assets and replace them with assets that haven't performed as well, remember that the goal is to maintain your chosen asset allocation. When one portion of your portfolio grows more rapidly than another, your asset allocation becomes skewed towards the best-performing asset. If nothing about your financial goals has changed, rebalancing to maintain your desired asset allocation is a sound investment strategy.

Frequently asked questions