About half of Americans are invested in the stock market, and almost all of them are investing through a retirement account like a 401k. While individual stocks like GameStop and Tesla get most of the news coverage, these aren’t the stocks making most people wealthy. Much more wealth is being built through mutual funds, index funds, and ETFs in retirement accounts.
Unfortunately, many of the people investing in these funds don’t know what they’re doing. When I first started contributing to a 401k, I had no clue what investments to pick or how to understand the information they presented to me. And I had a finance degree! To help you navigate your 401k and make as much money as possible, here’s everything you need to know about how to pick good 401k investments.
You’re Investing for the Long Term
401ks are retirement accounts and are therefore designed for long-term investing. They’re so serious about this that they charge a 10% penalty if you withdraw your money before the age of 59 ½. Yikes!
The good news is that it’s a piece of cake to make money in the stock market if you remain invested for a long time. Historically, the stock market has always gone up over the long term, so if you invest for several decades, it’s almost guaranteed that you’ll make money.
The keys to making the big bucks are to reduce your risk exposure by investing in a diversified set of assets and to invest in funds that ensure your return will exceed your expenses. Here’s how to do both.
Understanding Your Investments
High expense ratios are your ENEMY! A fund’s expense ratio tells you how much they charge you to cover their administrative expenses. The higher the expense ratio, the more of your money will go to paying fees.
When going through your 401k offerings, select funds with an expense ratio of .5% or lower. Many funds offer expense ratios around .1% or lower, which is ideal. The high fee funds are going to try to tempt you to choose them, though.
Usually, funds with high expense ratios are actively managed. That means that a fund manager handpicks companies they think will provide their investors with higher returns than the market. Remember, the market goes up over time and usually provides investors with a positive return. Actively managed funds promise to provide returns that are ever higher than the overall market return, which is what tempts investors into paying higher fees.
Unfortunately, most of these funds fail. In fact, 68% of actively managed funds provide lower returns than the overall market. That means you’re paying more money in fees and receiving lower returns. That’s a terrible spot to be in.
Luckily, passive funds have much lower expense ratios because they track an underlying set of investments and seek the same return as the market. Since the fund manager doesn’t have to do extensive analysis to try to beat the market, the administrative expenses are much lower. Therefore, by investing in passive funds, you can expect to receive a higher return and pay less in fees. Now that’s a good deal!
A company’s market capitalization (market cap) is the total value of a company’s outstanding shares of stock. Large-cap stocks are typically worth $10 billion or more, mid-cap are worth $2-10 billion, and small-cap are worth under $2 billion.
It’s important to consider a company or fund’s market cap when choosing your investments because as a company’s market cap increases, its risk decreases, and vice versa. Large-cap companies are lower risk because they tend to be leaders in their market sector, are well established, and have been around for a long time. Mid-cap companies are typically in a growth phase and have the potential to provide higher returns than large-cap stocks, but their future is less certain, which makes them riskier. Small-cap companies are the riskiest because they tend to be in their infancy and are in emerging or niche markets.
If you’re more of a risk-taker, you can add funds that contain more small and mid-cap stocks into your portfolio, and if you’re more risk-averse, you can invest in funds that contain only large-cap stocks.
Simply put, a market sector is a part of the economy. Some funds are composed of stocks spanning many different market sectors, and some are only composed of companies in one sector, like technology or retail. Some funds also include international companies, while others only contain domestic ones.
It’s important to consider the diversity of market sectors in your funds when choosing your investments, again because of risk. The more market sectors you invest in, the less risk you have in your portfolio, and the fewer you invest in, the more risk you’re exposed to in your portfolio. When you’re invested in a broad range of market sectors, if one sector is doing poorly, the other sectors can minimize the effect the struggling one is having on your portfolio. Limiting your investments to only one sector or a couple of sectors exposes you to much more risk and potential losses.
Choosing Your Investments
Asset allocation is an investment strategy that seeks to balance a portfolio’s assets to match the investor’s risk tolerance. To do that, each asset makes up a certain percentage of the overall portfolio. This allows an investor to increase their percentage of risky investments if they’re seeking a higher return or to decrease their percentage of risky assets if they’re more risk-averse.
In general, it’s recommended that you reduce the risk of your portfolio as you age, but everyone’s risk tolerance is different. Overall, stocks are considered riskier than bonds, and international investments are riskier than investing in domestic assets. If you’re young and a risk-taker, you can invest more heavily in stocks and international investments and less in domestic bonds. If you’re older and more risk-averse, you can invest more heavily in bonds.
3 Fund Portfolio
A 3 fund portfolio is a very popular portfolio strategy that allows you to quickly put together a well-diversified set of investments at a risk level you’re comfortable with. To build this type of portfolio, you select 3 index funds, a US stock fund, an international stock fund, and a US bond fund.
Once you’ve chosen your 3 funds, then you need to determine your asset allocation. If you want a riskier portfolio, you can invest 80-90% of your money in stocks and 10-20% in bonds. If you’re more risk-averse, you can hold a higher percentage in bonds. The beauty of this type of portfolio is that it’s simple and can easily be tailored to meet most investors’ needs.
If the thought of having to build your own portfolio terrifies you, no worries. Target-date funds are for you. These funds determine your asset allocation for you based on your retirement date, and automatically invest in each fund at the percentage they recommend. This means you can invest all of your money into one target-date fund and get exposure to international and domestic investments, and to bonds. Target-date funds will also automatically reduce your risk exposure as you near retirement to minimize any losses you could experience right before retiring.
Managing Your Portfolio
Once you’ve built your portfolio, you’ve done most of the heavy lifting, but it is important to review your investments at least annually. Depending on how each of your investments performs, your asset allocation could get out of whack over the year.
If you began the year 90% invested in stocks and 10% in bonds, but stocks performed exceptionally well last year, you could have over 90% of your portfolio invested in stocks now. To return to the 90/10% asset allocation you desire, you would need to sell some of your stock holdings and buy more bonds.
Again, if this sounds like a lot of work, you can use a target-date fund. On top of them determining your asset allocation when you start investing, they will also maintain it for you over time.
It’s easy to get overwhelmed when trying to determine what 401k investments to pick. Luckily, there are only a few key things you need to consider to pick good 401k investments. You should keep your expense ratios low, manage your portfolio’s risk by diversifying your investments, and build a portfolio that will provide you with maximum returns at a risk level you’re comfortable with. And if all of that is still too complicated, target-date funds are there to save the day.