You’ve set yourself up for retirement success by enrolling in your employer-sponsored 401(k) plan. Good job, you!
Now it’s time to pick investments for your 401(k), which is likely the most intimidating decision you’ll make about your retirement until you actually retire. But don’t fret, choosing your 401(k) investments is actually easier than it sounds. This guide will walk you through how to pick investments for your 401(k).
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First, know that more important than where you invest is that you are investing.
“Neither a luxury sports car nor an older economy car can drive cross country on a quarter tank of gas,” says Christine Sivak, a financial advisor and retirement plan specialist with Signature Estate & Investment Advisor, SEIA. Likewise, the “perfect” investment mix will only get you so far if you aren’t filling your tank with regular contributions.
Sivak recommends aiming to contribute 10% to 15% of your pretax income, but more is always welcome each year. If this sounds “intimidating, start by saving enough to get the full benefit of any contributions your employer makes to your account and then increase your savings rate each year,” she says.
Once you have your contributions set up, you can turn your eye to choosing investments for your 401(k). But, again, don’t worry about finding the “perfect” fund; you just need one (or ones) that will let you start investing your retirement savings. You can always change where you invest, but you can’t get back the years of growth you miss by not investing at all.
How to pick investments for your 401(k):
— For the one-fund, set-it-and-forget-it approach, use target-date funds.
— For a one-fund, don’t-forget-it-forever strategy, use target-risk mutual funds.
— For a simplified DIY portfolio, use the three-fund approach.
Step One: Determine Your Allocation
Asset allocation is the proportion of stocks, bonds and other investments you have in your portfolio. The reason allocation is so important is that it determines the risk level of your portfolio.
There are two ways to look at risk when investing: how much risk you need to take to get the return you want on your investments (more risk equals more potential long-term return), or how much risk you can tolerate without wanting to get off the roller coaster.
In general, the longer your time horizon, the more risk you can afford to take. If you have 25 or more years to retirement, you can hold more stocks to maximize your portfolio’s long-term growth potential. But if market volatility prompts you to sell prematurely, there’s no point in using an aggressive portfolio even if you want that level of return.
If you’re the type of person who knows the market will go up and down and you’re not going to worry about it, you can tolerate risk, says Chad Parks, founder and CEO of Ubiquity Retirement + Savings. But if you’re the type of person who worries about your investments and wants to check on them every day like a new mother making sure her sleeping baby is still breathing, you’re better off investing more conservatively.
An easy way Sivak suggests for estimating the appropriate proportion of stocks for you is to subtract your age from 100 (for more cautious investors) or 110 (if you’re willing to take on a little more risk). For example, if you’re 25 and don’t mind some bumps in the road, you could use 110. This would indicate you should invest 85% (110 minus 25) of your portfolio in stocks and the remainder in bonds or cash-like investments.
You’ll then want to diversify your stock and bond holdings across different types of funds, which we’ll cover in the next section. First, it’s important to understand that no matter how risk-loving you are, as you near retirement, you should scale back your aggressiveness to protect your portfolio from potentially disabling losses just when you’re about to start withdrawing. With this in mind, a person’s 401(k) asset allocation could look like this over time:
[CHART]
Please keep in mind this is a very general allocation plan. The closer you get to retirement, the more important tailoring your investing strategy to your personal situation becomes.
[READ: 10 Stocks That Have Doubled Their Dividends in 10 Years]
Step Two: Pick the Investments for Your 401(k)
Once you decide how much you want to invest in stocks versus bonds, you can pick the 401(k) investments to create your desired portfolio. Naturally your investment options will be limited to the funds available in your plan, but if they’re available, the following are all good options.
The one-fund, set-it-and-forget it approach
Target-date funds were designed with 401(k) investors in mind. These funds become gradually more conservative as they near their retirement date target. Simply choose the fund that corresponds with your retirement year and the fund manager will take care of the rest.
These are great if you just want to set up and-forget your 401(k) — at least in the beginning. As you near retirement, you may want to add other funds or replace your target-date fund with a more individualized investment strategy.
The one-fund, don’t-forget-it-forever strategy
Target-risk mutual funds, also called asset allocation funds, are designed around a target asset allocation instead of a retirement date. A 60-40 fund will maintain a 60% stock to 40% bond exposure indefinitely. So, you don’t need to worry about rebalancing because the fund does it for you.
The caveat is that since the fund won’t change its allocation over time, if your situation changes, you’ll need to find another fund or add funds to counterbalance it. Your asset allocation fund won’t become more conservative as you near retirement, so you’ll want to switch to a more conservative target risk fund later or add a bond fund to your portfolio to reduce your overall risk.
The managed account
The biggest drawback to target-date and target-risk funds is their lack of personalization. They’re designed for the average investor and can’t incorporate the unique aspects of your situation. If you want more personalization and your plan offers them, a managed account could be worth the extra cost.
“The benefit is that you receive personalized investment recommendations which take into consideration not only your age, but also your salary, savings rate and account balance,” Sivak says. You will pay an additional management fee for this on top of the fees for the funds used in your portfolio.
If you choose to go this route, know that the quality of the strategy depends on the quality of information you provide the account manager. You should share “information about any savings and assets you have outside of the 401(k) plan, as well as any additional income sources,” Sivak says.
The simplified DIY portfolio
If you want to have your hands closer to the steering wheel in your 401(k), you can always design your own portfolio from the various 401(k) investments available. The trick here is finding the right funds to match your goals.
This is where understanding the principle of diversification is key. Sivak likes to use a baseball analogy to illustrate this: “Just like professional baseball players specialize in a specific position, each fund … has a designated asset class or position.”
For example, the fund may specialize in large U.S. companies or small international companies. It may invest only in technology funds or use a mix across all sectors. Bond funds may hold high-quality or low-quality bonds, or a mix.
Just as baseball teams spread their players across various positions to improve the odds of getting the batter out, you should spread your savings across different investments to improve your odds of long-term success.
“You may end up with six to 10 funds, depending on your desired stock to bond mix and the investments” offered by your 401(k) provider, Sivak says. For example, your portfolio could include funds in each of the following categories:
— Large-cap stocks
— Mid-cap stocks
— Small-cap stocks
— International stocks
— Core bonds
— International bonds
— Money market or a stable value fund
That said, you don’t have to spread yourself quite so thin, especially if you’re just starting with a small balance. A simpler DIY investing strategy is the three-fund approach:
— A U.S. total stock market index fund
— An international total stock market index fund
— A U.S. total bond market index fund
Each of these asset classes are distinct enough that they won’t all be up or all down together. Translation: You’ll be diversified. If you want to diversify even further, you could add a real estate, commodities or alternative fund to the mix.
Pick one fund for each category — remember, it doesn’t have to be the perfect fund; if you have more than one option just choose the cheapest one — and use the allocation you chose in step one to determine how much to invest in each fund.
You can adjust how aggressive your portfolio is by tweaking the percent you invest in each fund. Dial up risk by increasing your stock exposure or dial it down with more bonds. With only three funds to juggle, you can still tailor your risk without giving yourself a headache when it comes time to rebalance, which you should do every six months to a year.
Step Three: Keep Costs Low
Whichever 401(k) investment approach you use, aim to keep the expense ratio of your funds as low as possible. You can’t control how well your investments perform, but you can control how much you pay in fees. Parks recommends keeping the expense ratio (the amount of your investment that will go toward paying fund costs) on your 401(k) investments below 0.5%.
Index funds are a great way to do this since they generally have lower expense ratios than actively managed funds. To find the index funds in your 401(k) investment options, sort the available funds by expense ratio from lowest to highest. The cheapest funds will most likely be your index funds.
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How to Pick Investments for Your 401(k) originally appeared on usnews.com
Update 08/07/25: This story was published at an earlier date and has been updated with new information.
