How to Invest Your 401(k)
Both clients and friends often ask me how they should be investing the funds in their 401k plans. It’s a fair question. Many people feel lost and overwhelmed by information when they look at the tables filled with dozens of fund options and hundreds of performance numbers. I want to help you cut through the numbers and focus on the numbers that you need to know in order to build a well-diversified portfolio. Before we get into the specifics of how to design the portfolio though, let’s take a step back and focus on the purpose of your 401k. If you’re like most investors, you probably don’t have a pension. Most employers don’t offer them now since 401k plans are cheaper for them to administer. Instead, you have a 401k to provide money for retirement. In order to maximize your retirement, you need to do two things: the first is to make sure that your money is compounding through a diversified portfolio. Second, minimize the fees that you pay. Every dollar that goes toward expenses is a dollar that isn’t going towards your retirement on the beach. So essentially, your portfolio needs to maximize returns while minimizing fees. Sounds simple, right?
There are two main ways to build a 401k portfolio which follows these guidelines. The first is to build an allocation that considers your risk tolerance and investing horizon using individual index funds. This approach is a bit more work but it allows you to have a portfolio that is built specifically for you and your goals. There are a few benefits to building your own portfolio but the biggest is that you can match the level of risk in the portfolio with the level of risk that you’re willing to take. For instance, if you’re younger than you can have a heavier weighting in riskier investments because you have a long enough investing horizon for that to make sense. Alternatively, if you’re older and know that you don’t like volatility, you can move more of your money into bonds.
Most 401k plans provide the plan participant with a menu of funds in which they can invest. You can find the options in your plan documents. Depending on your company, you might have an awesome lineup of low-cost index funds, or you might have an awful selection of actively managed mutual funds with high internal expense ratios (ER’s). There are two important things to look for when you begin looking at your investment options. The first thing is whether a fund is actively or passively managed. Passively managed funds, also known as index funds, are your best option for long term growth. Studies have shown that index funds outperform actively managed mutual funds due to their lower costs. Index funds from Vanguard, Fidelity, Blackrock and Schwab are generally going to be good choices. Index funds will generally have the word index in the name, i.e. Total Market Index or S&P Index. The next thing to look at when considering funds is the expense ratio. Most index funds have low expense ratios but occasionally plan administrators will slip in an index with high fees. In a 401k, you shouldn’t have any net expense ratios above .5%, however it’s possible (and great!) to use funds that are much cheaper than that. A fund from Vanguard or Blackrock will have an ER of .04% to .15%. If you take nothing else away from this, you need to understand how important fees are when putting together your portfolio. Low fees mean more money in your account when it’s time for you to retire.
Once you’ve looked at your options, it’s time to select the actual funds and decide the percentage you want to invest in each fund. This is the fun part. Portfolios can range from incredibly simple, with only two or three funds, to incredibly complex. For now I’m going to stick with a simple three-fund portfolio which will work for almost anyone. The three-fund portfolio is a diversified portfolio which spreads your money between a total US stock fund, a total international stock fund, and a bond fund. By following this portfolio, you’ll own parts of every US and international stock, as well as a large number of bonds. Diversifying your investments is a way to hedge your bets and protect your portfolio against downturns in the market. In theory bonds move opposite of stocks, so when the stock market goes down, the bond market will go up. It doesn’t always turn out quite that way, but bonds do a good job of anchoring a portfolio and providing dependable returns over the long term. Diversifying your stock investments between US and international provides protection in the same way; different stock markets move at different times and provide differing returns. Investing money into each keeps you from putting all of your eggs into one basket. Here are some examples of the three-fund portfolio.
Schwab Total Stock Market (SWTSX)
Schwab International Index (SWISX)
Schwab Total Bond Market (SWLBX)
Fidelity Total Market Index Fund Investor Class (FSTMX)
Fidelity Total International Index Fund Investor Class (FTIGX)
Fidelity U. S. Bond Index Fund Investor Class (FBIDX)
T. Rowe Price
Total Equity Market Index Fund (POMIX)
International Equity Index Fund (PIEQX)
US Bond Enhanced Index Fund (PBDIX)
So now you know which funds to use. Next you need to decide on how much money to invest in each fund. First you need to decide how to split your allocation between stocks and bonds. The best rule of thumb for this is to use your age as the percentage of your portfolio that should be in bonds. For example, I’m 26, so 26% of my portfolio would be in a bond index fund. The rest of your portfolio should be in stocks. Each year you’ll need to rebalance between stocks and bonds so that your allocation stays matching your risk tolerance, which will become more conservative as you age. You want to be more conservative as you approach retirement because you have less time to absorb a downturn in the market. When you have decades before retirement, a 10% correction in the market is a buying opportunity. When you’re five years from retirement, a 10% correction could keep you from retiring on schedule.
When it comes to the percentage of your funds that you put into each fund, I’m a creature of simplicity. I prefer to split the allocation evenly between holdings, also known as equal weighting. In the case of the three-fund portfolio, my breakdown would be 26% bonds, 37% international, and 37% domestic. If you prefer to split it differently than that’s okay too. The most important part is that you have a low cost and well diversified portfolio. If you have a three-fund portfolio, or a variation of it, then your portfolio meets the criteria that we discussed earlier, namely that your portfolio maximizes returns while minimizing costs.
For those that don’t want to go through the hassle of selecting funds and picking the allocation, then rebalancing their holdings each year, there is another option! Target date funds are a great way to get full diversification in only one fund. Target date funds are a fund of funds and by that I mean that they’re made up of a mixture of stock funds and bond funds. The farther out from their target date, the more aggressive the investment allocation they hold. As the target date approaches, the amount of bonds held in the fund will decrease, lowering the risk. This means that target date funds are a hands off investment. You can set it and forget it. Target date funds are perfect for investors who want a simple investment to which they can contribute and not worry about anything else.
Most 401k plans will only have one set of target date funds from one fund family. One popular family of target date funds is the Freedom Funds family from Fidelity. Another is the Vanguard Target Retirement family of funds. Fees matter when considering target date funds just as much as when building a custom allocation. Fees on target date funds vary quite a bit, depending on the underlying holdings. The Fidelity funds are around .77% ER per year, which is getting dangerously expensive. On the other hand, Vanguard’s option is only .16% per year. If your 401k plan’s target date fund has an ER of greater than 1%, you’re probably better off looking at other investment options because that’s simply too expensive.
So to recap what I’ve talked about, you have a couple different options when you’re deciding on how to invest within your 401k plan. The most important things to consider are making sure that you’re positioning yourself for compound growth through proper diversification and that you’re minimizing your fees when possible by choosing funds which have low internal expenses. You can do this by both choosing the funds yourself and creating an investment allocation which is consistent with your risk tolerance and investing horizon or you can go the simple route and find a target-date fund which matches your investing horizon. Either is perfectly acceptable and will get you to nearly the same goal. It all comes down to how much responsibility you want to take for your own investing decisions.