Stop me if you’ve heard this one before.
You get a new job, go in for your first day, excited to get started. Six hours into an eight hour onboarding training, you get a packet from HR with a 40 page document about your 401(k). And, for the most part, you’re essentially left to set it up on your own.
You dig a little deeper and set up a certain percentage of your paycheck to go into your 401(k) directly. Now, it’s time to select the funds in which to invest. The million dollar question- where in the world to start?
I’ve seen plans have as many as 50 different funds options to choose from. And most plans give very little guidance on how to make your decision. So, what do you do?
A Very, Very Brief Primer on Mutual Funds
This probably warrants its own separate post, but before we talk about how to choose a fund, it’s important to know what exactly you’re choosing.
The funds available in a 401(k) are mutual funds. There are a wide variety of mutual funds, but the general idea is the same across the board. If you put $10,000 in a mutual fund, the manager of the fund will invest it into a wide variety of stocks and bonds. The fund manager then reallocates these investments over time according to the fund’s objectives. When you wish to withdraw your money, you recieve your portion of the funds growth (or losses).
Mutual funds are a great way to diversify your money. When you put your money into a mutual fund, you aren’t just buying a single company’s stock. Generally, you’re putting your money into hundreds of stocks and bonds within a single fund.
Every mutual fund has a different objective, and risk level. On one end of the spectrum, some funds only invest in smaller companies in Africa and Asia. These are considered very high risk/high reward investments. On the other end, some mutual funds only invest in US Government bonds. In turn, these are very low risk funds (that in turn, offer much less upside potential). Most funds are somewhere in between.
Your 401(k) Investments Should Be Fairly Aggressive Early in Your Career
There’s no right answer for exactly how much risk you should take with your investments. The amount of risk you take generally depends on two things- how much risk you want to take, and how long your money will be invested.
This second piece is the key here. Your time horizon for how long your money will be invested can sometimes override your risk preference. For example, even if you are a very aggressive investor who wants to take a lot of risk, it’s not a good idea to invest that money aggressively if you are planning on using your investments to buy a house in six months. If the market were to crash, you might not have enough money to buy that house.
The flip side is also true. If you’re investing for a long time, it probably makes sense to take more risk in your investments.
For millennials, the biggest risk to your retirement assets doesn’t have anything to do with the stock market at all. The biggest risk is inflation.
To phrase it differently, inflation has averaged around 3% every year. Meaning, that every year, the things you buy tend to get about 3% more expensive. If your investments for retirement aren’t at least keeping up with inflation, you’re essentially losing money. The investment risk for a retirement portfolio that averages 6-8% a year is well worth it. Particularly because a “less risky” portfolio averaging a 2-4% return could leave you with less money, inflation adjusted, than what you have today.
All of this is a long way of saying- if you’re in your 20s, you want to make sure you focus your investments on growth to maximize the portfolio’s value by the time you retire. Swings in value in your 20s and 30s are a small price to pay to beat inflation over time.
…But As You Grow Older, Make Your Retirement Accounts More Conservative
Just because a growth-focused 401(k) portfolio is right for you now, doesn’t mean it always will be. As you get older, shift some of your portfolio from stock funds to bond funds.
A good rule of thumb is to move 10% of your account from stocks to bonds every 10 years. That way, by the time you retire, your portfolio is likely to have a good mix of growth and income-focused investments, varying slightly depending on how much risk you’re comfortable with.
So, How Should You Invest? You Have Two Major Options
With all that being said, what funds should you choose in your 401(k)? While all plans offer different fund choices, you generally have two options:
Retirement Target Date Funds
Almost all plans have retirement date target funds. The name of these funds varies from institution to institution, but they generally contain “Retirement” or “Target Date” in the name, followed by a suggested retirement year.
If you decide to go this route, choose the fund that corresponds with your expected retirement date. The target retirement dates are typically stated in five year increments. For example, a 25-year-old expecting to retire in about 40 years might choose the “Retirement Target 2055”, since 2055 is about 40 years from the current year.
These funds can be a great option for one simple reason: simplicity. All of the stuff I describe above about how your investments should start out focused on growth, and become more conservative over time? Target date retirement funds do it all for you.
Target date retirement funds are designed to be, in theory, the only fund you “need” in your portfolio. They are well diversified, automatically rebalance, and become more conservative over time.
The only problem? They can be expensive. All mutual funds have some sort of cost associated with them that come out of your account. Typically, since target date retirement funds do this work for you, they can be much more expensive than other fund options in your portfolio. This could leave you with tens or even hundreds of thousands of dollars less when you retire.
I recommend doing a cost analysis of the different fund options in your portfolio using a site like www.personalfund.com. Or, I’d be happy to conduct a 401(k) review to make sure you aren’t leaving money on the table.
Build Your Own Portfolio
If you want more control, or lower fees, on your retirement accounts, you can build your own portfolio. The great news with this option is that it allows you to customize the portfolio to your liking using the funds available. And, this method typically costs less in those ongoing fees I mentioned above.
If you go this route, you need to make sure you choose anywhere from four to ten or so funds that span the various sectors of the financial markets. You want to have some exposure to large US companies and small ones. You should have a certain percentage of your portfolio in foreign stocks. And adding anywhere from 10-30% of your portfolio in bond funds is a good idea too.
If cost is the downside of the retirement date funds, complexity is the downside to this second approach. How you allocate your investments has a huge impact on your long term portfolio returns. You therefore want to make sure you have your funds weighted appropriately.
And, unlike with the target date retirement funds, you need to worry about keeping your funds balanced over time. What do I mean by this? Hypothetically, let’s say you choose two mutual funds for your 401(k) putting 80% of your 401(k) into the XYZ Company Stock Fund, and 20% into the XYZ Company Bond Fund. (Obviously, I made these funds these up to illustrate the concept. And, you probably will want to have more than two funds if you aren’t using a target date retirement fund. But, let’s keep it simple for now). Now, let’s say that this year, stocks have a bad year, and bonds have a relatively good year (again, all hypothetical). At the end of the year, even though you started 80% stocks/20% bonds, your portfolio might be 65% stocks/35% bonds, since the value of the stocks fell and the bonds rose.
When you are managing individual funds, you need to keep an eye on the portfolio being thrown out of balance in this way. Typically, I recommend logging into your 401(k) twice a year and rebalancing to bring the portfolio back to 80%/20%, or whatever weighting you choose, to make sure it stays in line with your overall investment objectives.
In practice, once you have the portfolio set up appropriately, it isn’t that hard to rebalance it twice a year. But, it a) takes a bit of time, and b) involves remembering to do it. For this reason, I include rebalancing my clients 401(k)s twice a year as part of my comprehensive financial planning package.
You ultimately have two options- use the readymade target retirement funds, and pay a higher cost, or select the funds yourself and manage them independently. There ultimately isn’t a “right” answer for everyone across the board. And of course, if you have further questions about your investment options, how to rebalance, or even just to get a second opinion, I’m only a call away.