The Most Important Things When Selecting from 401K Investment Options

Sparkplug bear1401K investing is actually really, really simple.  The main reason is that you re generally limited to mutual funds, which means you automatically get diversification just by purchasing a fund or two.  Most of the time, poor fund selection will just lower your returns by a couple of percentage points, rather than lead to disaster.  This may cost you a couple hundred thousand dollars or so at retirement, but considering you should have millions in your 401k at that point, such a mistake will not leave you on the streets.

The mistakes that most people make with a 401K aren’t the investments they make.  It is either not putting enough into their 401K (or waiting before starting to contribute) or pulling money out early to do things like pay off credit cards or start a business.  Those are the mistakes that will leave you on the streets during your elder years.  Poor fund selection will just mean the difference between rib- eye and chuck steak.

Still, knowledge is power and knowing how to properly select your 401k will provide you with more money at retirement.  Here are factors to consider, starting with those that are the most important:

1. Minimize cash.  You may think that keeping cash makes you safe, but inflation is eating away at cash positions all of the time.  The money you put into your 401k will be cut in half by the time you’re ready to retire if left in a money market fund.  Plus, even without inflation, you need higher returns or you’ll only be able to save up a couple of hundred thousand dollars by retirement – not enough to last 20 years, especially with healthcare costs.  Put that money into assets such as stocks and bonds ASAP.  Only start shifting into cash when you get close to retirement, and then only for money you’ll need in the next five, or maybe ten years.

2.  You should mainly be in stocks when you’re young.  I would actually say you should only be in stocks when you’re young, but those with less risk tolerance (the thought of seeing your 401k balance decline ever gets you queasy) may want to mix in some fixed income assets like bonds from the start).  Over long periods of time (ten to fifteen years or more), stocks will return four or five percentage points per year more than bonds.  That means your portfolio will double about every five or six years instead of every eight or nine years.  The difference will more than double the amount you end up with at retirement.  The gyrations in portfolio value you see will be higher with all stocks, but you’ll end up with more money in the end if you can accept the volatility.

3.  You should diversify your holdings.  Diversification means buying different kinds of stock (and other assets).  Because different parts of the markets do well at different times, you want to spread your money out to ensure that at least part of your portfolio will be doing well at any given time.  While it may see like this would cause your portfolio to go nowhere (one part would go down when one was going up, cancelling things out), because the natural direction of the market is up (the economy always grows over long periods of time because there are more people and they become more productive and can make more stuff), on average you’ll see an increase even though you’re diversified.  You just don’t want to miss out on a big rally in one sector because you’re concentrated in another. 

Diversifying in equities (stocks) means buying large caps (big companies) and small caps (small companies).  You should also look at holding both domestic (US) and foreign company stocks.  Buying into a small cap, a large cap, and an international fund should meet these requirements.  Note also that large caps tend to be international (Coca-Cola gets its money from all over the world), so you have some country diversification right there.  You can also diversify by buying growth stocks and value stocks through funds that specialize in each investing approach.  Each style will do well during different periods of time.

3.  You should minimize fees.  Here’s a little secret the fund companies don’t want you to know:  because they need to buy so many different stocks because of all of the money they need to invest, they will end up just doing as well as the markets over long periods of time.  This means that all of those high paid advisors and huge research departments, let alone the fund managers flying out on corporate jets to have lunch with CEOs of companies to talk about prospects next quarter mean absolutely bupkiss.  Funds with those expenses will do worse than those without because they will both have the same return (market returns) before expenses.   Don’t pay extra when you don’t have to.

The cheapest funds tend to be those that are not actively managed, such as index funds and ETFs.  If your 401K plan has the choice of these, select them instead of the actively managed funds.  If you don’t have a choice, choose the ones with lower fees while still diversifying adequately.  Less than 0.5% is good, less than 0.25% is great.

4.  Lean towards small caps and value.  Because small caps are small, they have more room for growth, which means a larger potential profit over long periods of time.  While you certainly shouldn’t put all of your money in small caps because large caps will do better during certain periods (see the paragraph on diversification), having a slight skew towards small caps will probably increase your return over your working career.  Likewise, in looking at past returns, the value investing approach, where stocks that are considered cheap are selected, has done better than growth investing, where stocks are selected that are growing rapidly.  This is particularly true during periods where stocks are falling since value stocks are already cheap.  You may therefore want to slant a little towards value, but not too much.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on investment strategies, stock picking, and other matters relevant to the investor. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Comments appreciated! What are your thoughts? Questions?

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