How to Choose Funds in Your 401(k)
Or any workplace retirement plan.
You’ve just graduated and started your first “real” job with benefits. You receive your 401(k) plan documents and enrollment form, and now you’re faced with a dozen or more investment options.
Or maybe you’ve been working for years in a job and contribute to your 401(k) every two weeks without thinking about where your money is going. Now you want to take a more active role in your investments.
Where do you start?
Unlike IRAs, 401(k)s usually have a more limited menu of investment options, and the funds you’re offered won’t necessarily be Vanguard index funds. So the typical advice to just invest in VTI and VXUS (total U.S. and total international stock market funds respectively) may not apply.
Your investment options will depend on the plan administrator. Your 401(k) will likely offer index funds. But some funds may charge high fees, may be actively managed (as opposed to passively managed like an index fund) or may invest in a strategy that isn’t appropriate for the average investor.
With that in mind, workers need some guiding principles for making the right fund choices in their plan. But first I should mention that while this article focuses on 401(k)s, feel free to insert “403(b)”, “SEP-IRA” or another workplace retirement plan in its place, as the same advice applies.
Here are three general rules you can use when selecting funds in your 401(k):
1. Find Index Funds/Low Expense Ratios
First, you should try to find index funds. Most 401(k) plans offer index fund options. These will usually be the funds with the lowest fees. Try to organize the list of funds by expense ratio and start with the smallest numbers.
Generally, you should look for funds with expense ratios of 0.25% or less and avoid funds with expense ratios closer to 1% and higher like the plague. But not everyone gets a choice. Sometimes you just have to swallow high fees to participate in a 401(k) plan.
2. Choose a Diversified Asset Mix
You should also diversify. For younger workers, this may be as simple as one U.S. fund and one international fund. A total stock market fund is ideal, but most 401(k)s offer an S&P 500 index fund. There may also be a mid- and small-cap fund or something called an extended market fund. You can combine these with an S&P 500 fund to approximate a total stock market fund with a roughly 80/20 allocation. But you can also just use an S&P 500 fund alone.
As for international, there might be a total international fund or developed and emerging market funds may be offered separately. If they’re separate, you can do 75/25 developed and emerging markets to recreate a total international fund.
Workers in their 40s and older might add a bond fund. Try to look for a total bond index fund or an intermediate treasury index fund.
Do your best to create a portfolio with a mix of U.S., international and bonds if you desire them. Risk tolerance will play a role in your allocation. More aggressive investors should forgo bonds. More conservative investors might add up to 40% bonds to their mix.
You may also see other types of funds, such as value funds, growth funds, sector funds and REITs (real estate investment trusts). Only add these funds to your portfolio if you understand what they are and the risks associated with them, but they aren’t essential.
3. Don’t Performance Chase
Many employees make the mistake of choosing investments based on what has performed the best recently. But recent performance is a poor indicator of future performance. Many investors thought large growth funds were the best investments in 2020 because they were outperforming the broader stock market. But the past year has seen tech companies, the main driver of growth’s outperformance, stumble and small value companies outperform the market.
The lesson here is that investments that have done well recently won’t necessarily do well going forward, and often the investments that will do well in the future are the ones performing poorly today.
Avoid chasing high-performance funds in favor of a diversified and balanced portfolio.
Wrapping Up
Unlike with an IRA, you don’t always have great investment options with a 401(k). Still, more than 90% of 401(k) plans as of 2020 had index fund options, so chances are you will be able to avoid excessive fees and actively managed funds.
If you can’t select low-cost index funds, at least try your best to create a diversified portfolio with what you have. Aim to pick a U.S. large-cap blend fund, an international fund and a bond fund if you want them in your mix.
What happens if you do nothing? That depends on the plan. Some plans have a target-date fund as the default option. I’ve written here about why those are generally poor choices for most investors. Other plans will simply keep your money uninvested in cash. This is by far the worst thing you can do. If your 401(k) contributions are sitting in cash, get the money invested ASAP. Otherwise, you’re losing out on hundreds of thousands of dollars over your career.
So to summarize:
Try to find index funds by looking for the lowest expense ratios
Diversify with U.S., international and bonds
Don’t chase recent performance
A workplace retirement plan like a 401(k) is often the first time someone is exposed to investing. Many workers don’t know how to navigate the complex task of choosing funds to invest in. But by applying these rules it becomes easier than you think.