How Do I Effectively Invest in my 401(k)?

A 401(k) (or 403(b)) is a great way to get started on your retirement saving.  For many people, it can be the simplest and have the lowest cost of entry.  It’s usually easy to invest in these with a few clicks in your company’s HR system.

Different 401(k) administrators organize and offer funds in different ways.  You may have virtually no choice in the matter (very few funds to choose from), or you may be overwhelmed by dozens of choices.

The first thing to research is whether or not you have a Roth option.  My previous article describes the benefits and situations where a Roth account makes sense.  If it’s not an option – no sweat – proceed with a traditional 401(k).

Next, we need to make sure your investment portfolio is diversified.  This isn’t complicated, and it’s not hard to do.  Diversify simply means that you spread your money around in multiple investment vehicles to spread out the risk.  If you’ve ever heard the phrase “don’t put all your eggs in one basket,” then you probably understand the concept of diversification.  If you had your entire retirement fund invested in Enron in the year 2000, you were destroyed soon after.  It’s advisable to diversify not just in multiple companies, but also multiple industries.

Likely your 401(k) has mutual funds to choose rather than single stocks.  This will inherently diversify your portfolio, because the funds are a compilation of stocks.

Most 401(k)’s have funds organized in the following way.  You will see Large Cap, Mid Cap, Small Cap stock funds.  There will be funds that say Global, and others that say International.  Some funds might be called Life Path or Target funds.  You’ll see Bonds, Money Markets, and Stable Value funds.  You may be presented with a Real Estate fund or two as well.

Let’s start hammering out what some of these funds are made of before we make decisions.

  • Large Cap Fund – Made of stocks of companies worth collectively over ~$10B when all stock value is calculated
  • Mid Cap Fund – Made of stocks of companies worth collectively between ~$2B and ~$10B
  • Small Cap Fund – Made of stocks of companies worth less than ~$2B
  • Global Fund – Includes stocks of companies from any and all countries in the world
  • International Fund – Includes stocks of companies from all countries except the US
  • Life Path / Target Funds – Funds designed under a theory that you should take more risk when you are young and less risk as you age.
  • Bonds / Debt – These funds have no stock. Their returns come from debt notes from companies.
  • Money Markets – These funds are invested in currencies globally, intended to completely eliminate risk and have extremely low returns.
  • Stable Value Funds – Low risk, low reward guaranteed investment options backed by insurance and bank contracts.

Now that we have some definitions clear, let’s explore what might be worth investing in.

First, let’s explore what not to invest in.  By definition, these aren’t investments at all.  Money Markets and Stable Value funds are not designed to make you any kind of significant money.  A money market is the sophisticated version of stuffing cash under your mattress.  A Stable Value fund is like buying a CD at the bank.

Next there are funds I would personally avoid.  There is no place in my portfolio for Bonds or Debt.  Yes, I know that the textbooks say you should have some in your portfolio.  These typically have lower returns over time than equities.  I personally am invested in no debt instruments.

Life Path & Target funds really ought to be avoided.  They’re too complex to understand, and you are effectively letting a fund manager be in charge of your investment plan.  They follow a complex formula that says early in your career you want high risk, and later in your career you want lower risk.  In my research I’ve found that even at the “risky” part of the fund, it’s still not a very aggressive mix.  These end up having high fees, low returns, and are too conservative.

I can hear you now, “Well Ryan, it seems you’ve painted yourself in quite a corner.  All you have left is equities.”  That’s right!  Over long periods of time, equities have a great track record.  Yes, they have bad years, but they also have incredibly awesome years (that usually follow the bad year, by the way).

When you invest in these funds consisting of equities, spread your portfolio across all the categories.  Over time, small caps make more money, but large caps are more stable.  I personally have 25% in large cap, 25% in medium cap, 25% in small cap, and 25% in international funds.  You may have different options, but do your best to have some cash in companies of all sizes, and in all industries.  If your company offers you industry-specific funds, try to limit yourself to 10% in any given industry.

Takeaways:

  • Avoid bonds and limit your investment here. They’re too conservative.
  • Avoid cash and stable funds
  • Avoid Target-Date funds and Life Path funds.
  • Spread your money across equities of all cap sizes.
  • Invest in some international funds as well.
  • Don’t overinvest in any given cap size, or industry-specific funds.
  • Don’t put very much money in your company stock.

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