How to Invest Your 401(k) and Find the Best 401(k) Investments
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A 401(k) is the largest chunk of most retirement nest eggs. Putting money in the account is just step one. Step two is investing it, and that can be intimidating. Here's an overview of how to invest your 401(k).
How to invest your 401(k) in 5 steps
Step 1: Come to terms with the idea of investing your money
Some people think investing is too risky, but the risk is actually in holding everything in cash.
Let’s say you have $100,000 in your 401(k). Uninvested, it could be worth much less than that in 20 years, because inflation will eat away at your money's buying power. But invest your 401(k) money at a 7% return, and you could have over $400,000 in 20 years — and that’s with no further contributions.
Step 2: Know your risk tolerance
Knowing how much risk you're comfortable taking with your investments can help you develop a long-term financial plan that's right for you.
Typically, investors take more risk with their 401(k) investments when they're young (while they have time to recover from any bear markets).
Investors gradually dial the risk down as retirement approaches.
Consider how you'll react if the market gets rocky and your portfolio begins to lose value. If that idea makes you nervous, you may want to take less risk. Talking with a good financial advisor can help you learn more about how much risk to take with your 401(k).
» MORE: Take our risk tolerance quiz
Step 3. Choose your 401(k) investments
Employers and plan providers tend to make a fixed number of investment options available in their 401(k) plans. Typically you can't invest in individual stocks and bonds in your 401(k), but you usually can invest in mutual funds, ETFs or index funds.
Your 401(k) will probably offer at least one fund in each of the following categories:
U.S. large cap: These primarily invest in very large American companies.
U.S. small cap: These primarily invest in relatively small and medium-size American companies.
International: These primarily invest in the markets, companies and financial instruments of non-U.S. countries.
Emerging markets: These primarily invest in the markets, companies and financial instruments of developing economies.
Alternative assets: These primarily invest in natural resources, real estate, private equity and similar instruments.
Bonds: These primarily invest in bonds from a variety of companies or countries. Many bond funds focus on certain types of bonds (such as high-yield bonds or I bonds), bonds from certain countries or bonds from companies in certain industries.
Careful asset allocation, which is the process of deciding where to invest your money, can spread out risk via diversification. That might mean putting 50% of your equity allocation into a U.S. large cap fund, 30% into an international fund, 10% into a U.S. small cap fund and spreading the remainder among categories such as emerging markets, alternative assets or bonds.
A shortcut some people use is to subtract your age from 110 or 100 to find the percentage of your portfolio that should be invested in equities. Using 110 will lead to a more risk-tolerant portfolio; 100 will skew less risk-tolerant. This method does not consider your personal financial situation, however, nor does it consider other important factors.
» MORE: How to retire early
Step 4: Minimize expense ratios
Expense ratios are the fees your investments charge, and they range widely. The fees are a percentage of the amount invested.
Index funds tend to have the lowest fees.
Index funds track an index, such as the S&P 500. Because there's little "stock-picking" or buying and selling for the fund manager to do, index funds are usually less expensive than a mutual fund, which is actively managed by the fund manager and thus may cost more.
Small differences in fees can have a huge effect over time. For example, if you’ve invested $100,000 at a 7% annual return, a fund with an expense ratio of 0.80% could eat up $70,000 more of your returns over 30 years than a fund with a 0.40% expense ratio.
Expense ratios are disclosed on your 401(k) plan provider website, as well as in each fund’s prospectus.
You can search for risk ratings for specific funds on your plan provider’s website or on Morningstar.com.
Step 5: Know when to outsource
If you’re nervous about the best way to invest your 401(k), there are two other things to consider:
Target date funds. Target-date funds, also called life-cycle funds or target-retirement funds, are mutual funds that automatically rebalance their mix of stocks, bonds and money market accounts as you age. Target-date funds invest in other mutual funds (a “fund of funds”) to build a diverse portfolio. Typically, the investor's intended retirement year is the "target date." These funds are common offerings in 401(k)s.
Hire a financial advisor. A financial advisor can help many investors understand how much risk they're willing to tolerate, calculate how much they should save for retirement, and decide the best way to invest their 401(k) money.
