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Choosing Funds in Your 401k

Posted on the 01 October 2016 by Smallivy

Clingdome2With the loss of the traditional pension plan, many employees are finding themselves needing to be investors if they want to have money at retirement.  The first things to understand about using in your 401k are the three cardinal rules:

  1.  Get in early, ideally when you first start a job.
  2. Contribute regularly, at least enough to get the full company match but ideally 15% of your salary.
  3. Do not touch the money for any reason until you are ready to retire (except to move it to an IRA if you change jobs).

If you don’t follow these rules, you have no justification to complain about the amount of money you have in your 401k at retirement.  It isn’t the plan – it’s your behavior that results in your not having enough money when you’re ready to retire if you break these rules.  A pension plan requires you follow each of these rules, where a 401k gives you the power to break them if you’re foolish enough.

But what about how you invest the money within the plan?  Won’t it take years of study or some fancy degree to know what funds to pick?  Luckily, it really isn’t all that difficult.  Here are some pointers that will help you along:

1.  The longer your time horizon, the more stocks you should own.  Personally, I have only stock and REIT funds (maybe 10%)  in my 401k since I do not plan to retire for at least 25 years.  While I know we could see drops like in the market like we saw in 2007, the risk of losing money due to inflation over periods of ten years or more is substantially more than the risk of losing money due to market drops.  In fact, it is nearly impossible if you’re investing regularly since the market goes up in about three out of four years.  By buying regularly, you buy more shares during market dips, meaning that even if the market is flat you’ll make money over time.

2.  Buy index funds.

There are two types of funds – managed and unmanaged.  Managed funds have a group of people who choose which stocks to buy.  They research companies, fly around the country and go to meetings, and have big holiday parties with the fees they collect from your 401k.  They also get bored and buy and sell stocks, often at just the wrong time, which costs you lots of money.

Unmanaged funds just buy a fixed group of stocks dictated by some index.  They only sell and buy stocks when the stocks in the index are changed, which is somewhat rare.  This means their costs are low.  Because a managed fund needs to buy lots of stocks because they have so much money to invest, they’ll end up basically getting the same return from their investments as the indexes even if the managers are good stock pickers.  Tack on their fees and you’ll do a lot better with an index fund.  Try to find unmanaged funds with fees of 0.25% of funds or less.  Avoid funds that charge more than 1%, even if they have a star manager.

3.  Diversify.

Once in a while, everything goes up or down at the same time.  Most of the time, one segment of the market will be doing well while others aren’t doing as well.  You want to make sure you are always invested in the portion of the market that is doing well.  You do this by basically buying everything.  A good 401k account will have a mixture of small and large stocks, and a mixture of momentum (growth) stocks and value stocks.  The easiest way to get there is to buy a total market index fund that buys everything.  Because small stocks will do better than large ones over really long periods of time, you might want to buy a large cap index fund and a small-cap index fund instead, maybe 60% small caps and 40% large caps.  You can also mix in some international stocks (10-20%).

You can also mix in some international stocks (10-20%) and maybe an REIT fund (10-15%), which will give you some exposure to real estate.  As you get closer to retirement, or if you don’t like 40% drops in your portfolio value, you can add some bonds (a total bond market index is good) and a money market fund to help protect you from downturns.  The latter is only appropriate when you’re a few years from needing the money since you’ll be losing money to inflation.

4.  Keep your balance.

You may start out with a 60/40 mix of small stocks and large stocks, but then a big run-up in small caps may change your mix into 70/30.  It is important to rebalance — sell the small stocks and buy more large stocks to bring yourself back to the 60/40 target.  This means you’ll be selling the stocks that are high in price and buying those that are lower in price.   You don’t need (or want) to do this too often because it is good to let your winners run for a while.  Just pick a month once per year, maybe the month of your birthday (or January is a good time), to rebalance.  Most fund companies have tools to allow you to do this in one step.  You can also change your contributions to regain balance.  For example, if you have too many large stocks, you can start buying only small stocks with new contributions.

You can also change your contributions to regain balance.  For example, if you have too many large stocks, you can start buying only small stocks with new contributions.  This strategy is particularly good if you have funds in a taxable account (not a 401k), where selling your winners might mean needing to pay taxes.  You want to avoid paying taxes for as long as possible to let your money compound.

Got an investing question? Please send it to [email protected] or leave in a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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