How to Choose the Best Investments Within Your 401K
401Ks and other employer sponsored retirement plans are some of the best resources to grow retirement funds.Tax deferred treatment immediately puts contributions to work, while lowering taxable income. Company plans feature significantly higher contribution levels than comparable individual options. They feature an uncomplicated process to sign up, and automatic payroll deductions lead to consistent deposits resulting in faster account growth.
The challenge with 401K plans is that enrolling in the program is only the first half of the process. To effectively build retirement accounts, you must direct contributions into the most effective investments based on your circumstances.Understanding the following parameters will help you narrow the offered options and choose the most appropriate funds.
The first consideration when choosing funds is your age and comfort with market risk. Ask yourself these questions:
What is your time horizon? Distance to retirement gives you a starting point.The farther youhave until retirement, the longer your money will grow in the account and the lower the impact of current market conditions.As you near retirement, there are fewer years to gain back losses, resulting in more conservative selections.In general, you can be more aggressive with the fund selection when you have time to recover from market corrections.
How do you handle market risk? All investments have arisk. Conservative choices may not have the same volatility, but often feature low returns that may not keep up with inflation. Market risk considers the movement of the overall market, which continually shifts up and down based on market conditions.One category of funds can rally one year and fall the next. Your comfort with these movements will help you decide how conservative or aggressive you want your portfolio.
What Allocation Meets Your Risk and Time Horizon
Asset Allocation. You can select to put 100% of your investment in one fund or divide it among different investments. Mutual funds choose company stocks or bonds based on the fund guidelines. For example, a large company fund can only invest in companies with over 10 billion and small cap funds must invest in companies with under 2 billion in market capitalization. Choosing an investment in a balanced, life or target date fund gives fund managers more flexibility in investment choices, although these funds tend to have higher expense ratios.
Mutual funds compile a basket of stocks and/or bonds into a single fund for better diversification and lower risk than purchasing an individual stock or bond. They fall into various categories based on the size of the company, industry, and investment style. You can choose stocks or bond funds and growth or value funds. When you invest in a bond,you lend the company money, and when you buy a stock, you gain partial ownership. A growth fund focuses on trends and the prospects of growth, where value funds look for undervalued stocks.
Company size often referred to as “caps,” gives you the choice of large, mid, and small cap funds, each focusing attention on companies based on size. Small cap companies range from 250 million to 2 billion, mid cap companies have between 2 and 10 billion, and large cap companies are over 10 billion in market capitalization.
401Ks often include funds focused on international companies (outside the US) or global funds (companies anywhere in the world), along with emerging market funds which target companies specializing in developing countries and markets. Typically, 401Ks do not provide choices focused on specific sectors or industries, except for company stock purchases.
What is the cost of each fund? The price of operating the fund is an essential element in the investment decision. Higher fund costs have a direct effect on returns; fees directly reduce profits.Some funds have an expense ratio of less than 1%, while others can cost up to 3%.
Asset allocation and fund fees are two key aspects of the overall performance of your 401K. Ideally, you want to create diversification to reduce risk while maximizing gains.
Potential Allocations
A conservative investor might choose 70% to 75% in fixed bond funds, where an aggressive portfolio might have that higher percentage of stock funds. More conservative investors will select more large company funds as opposed to small cap and emerging markets.
Fixed income securities include bonds and investments with guaranteed returns or a set interest rate. Equities include stock funds. It is possible to be more conservative with bonds by investing in higher risk companies or more conservative with stocks by investing in larger more stable companies and industries.
Investing the majority of funds in equities or stock funds provides an increased opportunity for profits, but can result in higher levels of volatility. More aggressive allocations near retirement could result in withdrawing funds when balances have declined due to market conditions.
Investment Strategies
Low Maintenance Option
Target date funds may cost more, but they automate asset allocation based on your age and the number of years to retirement. The fund automatically adjusts investment choices based on your time horizon.
Low-cost Option
Index funds track a set index and are not actively managed, giving them the lowest expense ratio.
When choosing your investment strategy, consider not only your 401K, but all your long-term investments such as IRAs, brokerage accounts, CD’s, money market accounts, and spousal accounts. Retirement investing is one piece of the financial puzzle you create to build your financial future.