6 Tips for Making the Best 401(k) Investment Choices

July 18, 2012

Investing for retirement can be an intimidating undertaking. Setting aside money in your 401(k) plan is difficult enough, but determining how to invest it presents its own set of challenges. The good news is that you don’t need to be a seasoned, savvy investor in order to make the right choices. In fact, once you determine your risk tolerance and know what to look for in a fund, picking the right one is largely a process of elimination.

1. Determine Your Level of Risk
The younger you are, the riskier you can afford to be. Historically, the stock market has fluctuated greatly, but has, over the long-term, continued on an upward trajectory. Therefore, the prevailing theory is that the more time you have, the less likely a down market is to have long-lasting effects, as you are more able to ride the upward trend.

Some experts suggest that younger investors (those who are 15 or more years away from retirement) invest 100% in stock funds. However, you must know your risk tolerance to make sure you’re not invested too aggressively, or else you could pull out of the market at the wrong time.

2. Research Your Options
Your employer can provide you with a list of available funds, but it’s up to you to decide how to invest. Once you’ve identified your risk tolerance, narrow down to the funds that match it. For example, if you’re conservative by nature, an overseas emerging markets fund would likely be a poor choice.

Visit a website like Morningstar to get a better sense of how risky each fund you’re considering is, along with other important information. Search using the alphabetized list of funds or by entering the fund’s stock ticker.

3. Investigate Fees
When you’re investing for the long-term, annual fees are a crucial consideration. A recent study showed that a median-income household with two wage-earners pays almost $155,000 in fees during their working lifetimes. A 2% management fee can easily take 33% of your money over 10-15 years. Ideally, you should invest in a fund with an annual expense ratio less than 1% – or at least less than 1.5%, which is the industry average. Also, be aware of funds that have a sales charge or front-end “load.” This can be more than 5% of your investment and is deducted from your contributions.

Both the annual expense ratio and whether the fund charges a load is readily available via Morningstar. Also, beginning in August, retirement plan providers are required to disclose the annual expense ratio on your statement.

4. Consider Long-Term Performance
When you research individual funds, you are provided with a variety of performance histories. It’s best to exclude performance histories less than five years in duration – the reason being that you need to see whether the fund has beaten its benchmark index consistently.

Also, look at how funds perform in down market years. Some funds are more defensive with risk management than others and aim to avoid huge losses, even when the rest of the market is tumbling. Though past performance is no guarantee of future results, these steps can help identify a fund that has a good investment model and management.

5. Diversify
Many experts suggest that diversification is key to any successful investment strategy. Although most funds are intrinsically diversified, ensure that you are adequately diversified across a range of assets and industries. Choose a healthy balance of stocks and bonds, large and small cap funds, international investments, and – if you have the stomach for it – a small percentage in commodities. Diversifying your portfolio protects against short-term fluctuations, and can minimize the effect of down markets.

6. Review Regularly
Keep tabs on your investments and thoroughly review them at least once per year. Ideally, you want to choose good investments and stick with them as long as they remain strong – and as long as they remain suitable for your situation and goals.

However, your financial situation will likely change, and some funds may become poor investments. If you find yourself in funds that consistently lag their benchmark index, it might be time to look at alternative investments. Also, as you near retirement, you should scale back your level of risk. That said, what you don’t want to do is obsess over your portfolio or move in and out of funds too frequently.

Final Thoughts
If your employer offers a match program, it’s in your best interests to bump up your contributions at least to this level. Simply put, this is free money. If you’re struggling to come up with funds to get to that point, there are a myriad of ways you can save extra money to make up the difference: clip coupons to save on groceries, adjust your thermostat to save on home energy, or scale back your cable TV package. These short-term sacrifices can help you invest in your 401k plan, which can yield huge returns over the long run.

What other tips do you have for investing in your 401k plan?