Trying to find the right investments for your 401k can leave you feeling like you are lost in the middle of a maze. Your 401k plan provider may offer a ton of investment options including stocks, stock funds, bond funds, and exchange traded funds. With so many options to choose from, what is an investor to do? No need to worry! Here are 5 steps that will help you navigate through your 401k options:
1. Determine what type of investor you are
Are you an aggressive investor that loves to take on risk? Are you a conservative investor that gets jittery every time your portfolio drops? How long do you have until retirement? These are just a few of the questions that you need to ask yourself. Aggressive investors with longer investment horizons should allocate a larger position of their portfolio to equities and equity funds. Stock funds carry more risk and have greater potential for capital appreciation than other assets. Conservative investors should have a heavier percentage invested in bonds, money market accounts, and cash.
2. Structure your portfolio to handle market fluctuations
Many 401k participants place their entire retirement in just one asset class. Never invest any more than 20% of your money in any one investment. This includes your company’s stock. Your monthly income is already tied to your company’s performance. You don’t want your retirement plan tied to them as well. You could easily lose your entire retirement if the bulk of your money is invested in company stock. Investors at Enron, Worldcom, and Lehman Brothers learned the hard way the penalty for not diversifying. If you make the mistake of picking an under performing fund, your entire portfolio can suffer. Diversification is an investor’s best friend. Diversification allows one area of your portfolio to rise when another area may be struggling.
3. Free yourself from the headache of asset allocation
Do you want to free yourself from the headache of restructuring your portfolio? If so, then a target date fund might be right for you. Target date funds are a good option for investors that don’t feel like being bothered with choosing between the many options and mutual funds of a company’s 401k plan. Target date funds are like putting your portfolio on cruise control. All you have to do with target date funds is pick funds with the date closest to your retirement year. For example, assume you purchased a target date fund with a maturity date of 2030. The fund would initially start with a heavier allocation toward stocks. As each year passes, the stock portion would decrease and the bond allocation would increase. By 2030 most of your assets would be invested in conservative assets. Target date funds free you from the hassle of restructuring your portfolio by re-balancing automatically.
4. Take a low cost approach
Want to reduce the fees charged by your 401k retirement plan? Take a look at index funds and index ETF’s. Index Funds will give you exposure to different markets and ensure that you get a comparable return to the overall market. There are a variety of index funds including funds that track the S&P 500, large cap stocks, small cap stocks, mid cap stocks, international markets, bond markets, and so on. Exchange traded funds (ETF’s) have become quite popular in recent years. According to AOL’s Daily Finance site, $4 billion dollars worth of exchange traded funds are currently invested in 401k’s. Many investors favor the lower costs and fees associated with index ETF’s and index funds over actively managed funds. There is also a lot of research out there that says actively managed funds perform no better than passively managed funds.
5. Know exactly what you are buying
What is the difference between a growth and a value fund? Growth funds primarily invest in stocks with above average earnings potential. Value funds will buy distressed stocks that are out of favor. A blended fund is a hybrid fund that contains both growth and value stocks. What are the benefits of large caps vs. small caps? Large cap funds are much more stable than small caps because they invest in well established blue chip companies. Small cap companies are riskier but have a greater chance of capital appreciation. Large cap funds are much more likely to pay dividends.
It is important to consider all of the investment options available to you. Any of these options may work for you depending upon your age, risk tolerance, investment horizon, and retirement date. You may want to take a hybrid approach and combine a few of these options. Be sure to do your homework and ask your plan provider any questions that you might have. Making the proper choices now can help ensure that you have enough money to make all of your retirement goals come to fruition.
This is a guest article written by investment management professional, Mark Riddix, who is also a staff writer at the Money Crashers personal finance blog. Feel free to check out the site for more useful investing articles like this one and subscribe to their RSS feed to get daily updates.