Deciding Where to Invest
So far, all of this 401(k) decision-making has been pretty easy. Now it is time for the fun part -- deciding exactly how and where you want to invest your hard-earned dollars.
Your typical 401(k) plan may offer 20 or more investment choices, including:
What are the differences in these? How you should split up your dollars to get the most bang? Most likely, your plan administrator won't be advising you on exactly where to invest. It's too much of a liability. First, let's go over what all of the options listed above actually are.
- Stock mutual funds
- Bond mutual funds
- Stable value accounts
- Money market accounts
Money-market accounts and stable value accounts usually consist of certificates of deposit and U.S. Treasury securities. They are very secure, and offer small but steady growth.
Bond mutual funds are pooled amounts of money invested in bonds. Bonds are basically IOUs that companies or governments issue. Bonds are paid back with interest that is usually a fixed percentage of the amount purchased. When a bond within the mutual fund reaches maturity, the proceeds are used to purchase different bonds for the portfolio.
Stock mutual funds are portfolios of company stocks. When you buy stocks, you are buying a small part of the company. Stock mutual funds, like bond mutual funds, are managed by a professional money manager. Each company's stock within the portfolio has a different value that will fluctuate based on the company's business success. The mutual fund's share price is determined by its net asset value, which also fluctuates with the circumstances of the companies within the fund.
The first important decision you have to make is what kind of risk you are willing to take. You can take the conservative route, which will mean lower returns but a lower chance of losses. Or, you can take a moderate route, which includes a mix of risky and conservative options and moderate-to-low returns. Or, you can be aggressive and go for options with high earning potential but also higher risks. As a fund's potential return increases, its level of risk increases. Risk is essentially the fluctuations that will be a part of any fund's existence. This means that the time frame in which you have to invest will greatly affect the plan of attack you decide on for your 401(k) investments.
For example, if you are going to need the money sooner than later, then your risk tolerance will be lower and you'll need to choose low-risk investments with a more consistent and stable history of returns. You can also lower your risk by diversifying your investments.
If you have many years of investing ahead of you (10 or more), then you can probably afford to take more risks. The longer you have your money invested, the longer you will have to recover from any losses.
Your own personal feelings toward investing are also a big factor. Stressing over investments is not good for anyone. Think about what risk you are comfortable with and then plan your investments accordingly. Remember that most plans let you rearrange or "rebalance" your funds at least quarterly, and in some cases you can rebalance as often as you want.
Making your selections
Of the choices you have, the riskiest, but also the option with the most earning potential, are stock mutual funds. Historically, stocks as a whole have had average annual returns of close to 11 percent. The tricky part is to select the right stock mutual funds. How do you know which are the best performing funds? According to an article by the Motley Fool, "Over time, the absolute best performing type of stock mutual funds, bar none" is an index fund. An index fund essentially matches the market. It has no manager and is simply made up of representative amounts of each stock in the index. It is the safest bet on achieving a steady rate of return that can come very close to or match that 11-percent average.
There are several index funds. The most well-known is probably the S&P 500 index. This index fund performs well, but there are also others that perform well -- such as the Wilshire 5000. Because it is very difficult to pick stocks individually that outperform an index like the S&P 500, it makes a lot of sense to invest in an index fund. The same article by the Motley Fool states that index funds outperform between 80 percent and 90 percent of actively managed equity funds.
The problem comes in when your 401(k) plan does not offer an index fund. What do you do then? Part of the boost in an index fund's value comes from the fact that is not actively managed, and therefore doesn't have the fee associated with that management. You can put together some funds that might act like an index fund, but it will take some work. The first things you have to look at are the fees and commissions that are charged. Look for a fund that has management fees less than 0.75 percent, no sales charges, and no 12b-1 fees. (12b-1 fees are annual fees that the fund uses for its marketing efforts.) You also want to look for a fund that has low turnover of stocks -- that typically means that it performs well. The fund's past performance is also a good indicator of future success, but is not a guarantee.
Do your homework
Don't blindly choose stocks without knowing anything about them. Do a little homework. Your plan administrator should have information available for you about each fund. These are often available online as well. Read the prospectus of each fund and select the ones that you find fit best with your own philosophies and ideas.