How to Invest in Your 401(k) Plan
One of the most widely touted New Year’s Resolutions is the sign up for your company’s 401(k) plan and then invest wisely. For most people, the latter step is easier said than done.
Joining the plan is easy: Get the enrollment forms from your HR department and decide what percentage of your salary to contribute. Try to contribute at least enough to get any match your employer offers, because a) it’s free money; and b) it’s the amount you put in that makes the biggest difference in how large your nest egg will grow. (See this study for an explanation.)
Below is a fairly straightforward guide to allocating your 401(k) (my apologies for the long post). It involves three main steps: Decide how much risk to take; choose different kinds of investments; then select specific funds.
First, take a risk: A classic rule of thumb suggests you subtract your age from 100, and invest that amount in stock mutual funds, the rest in bond funds. (So if you’re 25, put 75% in stocks, 25% in bonds.) But this is totally up to you – when I was 25, I had 100% in stocks, because I knew I had 40 years to invest. Now, with retirement about 25 years away, my split is roughly 60-40, stocks to bonds. If you have no clue how much risk to take, try this risk tolerance quiz from Rutgers University.
Next, choose an investment style for your stock funds: “growth” funds are considered the highest risk; “value” funds the most conservative; “balanced” funds strike a middle ground. Then divide up your stock allocation among different types of funds. A common strategy is to put 70 percent in a “large-cap” fund; 20 percent in a “mid-cap” fund; and 10 percent in a “small-cap” fund. (These funds invest in large, medium and small company stocks, respectively.)
This is because the market moves in cycles. For instance, demand for small-cap stocks may soar while large-caps decline; then the pattern might reverse. Spreading your portfolio over different types of funds improves its performance. Some people also want their investments to include companies in other countries to get even more diversity; for instance, I have about 12 percent of my stock allocation in international stocks.
Now head to Morningstar.com, the indispensable guide to mutual fund research. Click the “Funds” tab. Under “Fund Family Data Pages” search for the name of the fund company offered by your 401(k) plan administrator (Fidelity, Vanguard, etc.) Here you’ll find reports on each fund your plan offers. Click on “Data Interpreter” for a layman’s explanation of the numbers. Then print the reports out, and begin the process of elimination:
• Eliminate any funds ranked one or two stars. Morningstar ranks funds from worst (one star) to best (five stars) based on performance and risk.
• Eliminate any fund in which the “percentile performance number” is below 50 (such funds perform in the bottom half of their peer group).
• Eliminate any fund with an expense ratio above the category average; see “Fees and Expenses” for the average. (This is the cost of owning the fund; lower costs mean better returns.) • Eliminate any fund where the manager’s “start date” is less than five years ago. You want the person who racked up great returns in the past to be the same one running the fund now.
• Pick a fund where the returns over the last 1, 3, and 5 years matched or outperformed the average for the category, and/or the relevant benchmark listed by Morningstar (such as the S&P 500).
Hopefully, this process will leave you with a few funds to choose from in each of your investing categories. Call each fund, order the prospectus, and read it before making your decision.
Finally, some 401k plans simplify this process by offering “life-cycle” or “target-strategy” funds. In this case, you can choose a single investment and still get diversification, because these funds allocate your money among both stock and bond funds based on your age, and then gradually shift to more conservative investments as you age.
Still overwhelmed? Get advice from a certified financial planner that charges by the hour at garrettplanningnetwork.com.
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