Signing up for an employee-sponsored 401(k) account is one of the most important steps that people can make toward a financially secure retirement. Investing retirement savings early helps these funds grow quickly and exponentially over time.
Once a 401(k) account is opened, however, individuals will need to choose their investments. For many people, seeing all the options available is very overwhelming, but the trick is to approach the decision in a systematic way and understand that choosing to invest is more important than choosing specific investments.
After all, individuals can always decide to reallocate their investments, especially as their goals and risk tolerance change over time. Here’s a three-step process for choosing your 401(k) investments:
Step 1: Determining Asset Allocation
The first step in choosing investments for a 401(k) is deciding on allocation, which means the proportion of stocks to bonds and other investments. This determination is the primary way to control risk. Individuals should understand that more risk typically translates to higher returns, but too much risk can cause individuals to lose out on money.
When saving for retirement, people typically reduce their risk over time. When they have decades before they retire, they can afford to be risky since they have more time to recover if things go wrong. However, personal preferences also apply. Individuals who can tolerate the ups and down of the market without getting nervous could tolerate a riskier portfolio.
When it comes to allocation, stocks are much riskier than bonds. However, stocks have the ability to generate much higher returns. The returns on bonds are predetermined, so their potential for growth is limited, although there is potential for selling bonds on the market if interest rates change.
Typically, as a person draws closer to retirement, the percentage of the portfolio made up by stocks decreases as the percentage of bonds increases. Individuals will need to tailor their investment allocation according to personal situations and expectations.
Step 2: Choosing Specific Investments
Once individuals have gone through the work of determining how much they want to invest in different asset classes, they can create a portfolio. The specific products available will vary according to plan, so it is important to look at what is available before creating a specific strategy. Individuals also need to consider how active they want to be in managing their investments before they choose specific funds.
Some individuals like to be rather hands-off with their investments. These people should think about target-date funds. With these funds, a specific retirement year is specified and the investments automatically get more conservative as the retirement year approaches.
Investors simply need to choose a fund that corresponds with their predicted retirement year. However, it is also wise to look at some other details of the fund to make sure that its strategy and management are acceptable. With that homework done, individuals will need to do very little else to manage their investments.
People who want more control over decisions can design their own portfolios. Many individuals opt for the three-fund approach involving a stock market index fund, an international stock market index fund, and bond market index fund. For further diversification, investors can choose a commodities, real estate, or alternative fund as a fourth investment.
The amount invested in each of these funds depends on risk tolerance and the allocation chosen in the first step. Ideally, individuals opt for funds with a low expense ratio, which indicates how much of the investment goes toward administrative costs. With this strategy, people should rebalance every six months to one year.
A Middle-of-the-Road Approach to 401(k) Investments
For individuals who want some control over investments without taking a completely do-it-yourself approach, another option exists. This option is the target-risk mutual fund or asset allocation fund. These funds are based on risk rather than retirement year. For example, a 60/40 fund will invest 60 percent of money in stocks and 40 percent in bonds.
A fund manager monitors these options to keep the asset allocation fairly consistent, which eliminates the need to rebalance personally. With this option, investors will only need to change their strategy when their situation changes. Individuals can either find a completely different fund or add another fund to counterbalance. As people get closer to retirement, they will want to opt for more conservative investments.
Step 3: Control Fund-Based Expenses
Individuals have no control over how well their investments perform. Naturally, everyone wants their investments to perform well so that earnings can compound over time and provide them with a nice nest egg in retirement. While there is no control over performance, people can control how much of their money goes toward the costs of investment.
Funds have vastly different costs associated with them and understanding these expenses is crucial to maximizing savings. Each fund reports an expense ratio. This lets investors know how much of the money in their account goes toward the fees associated with the investment. Keeping 401(k) investment expense ratios below the 0.5-percent mark is a decent rule of thumb to avoid seeing one’s investments hindered by fees.