The 401k is one of the best retirement savings vehicles available. Not only are your investments tax deferred, but most of the time there is an employer match. Nearly everyone has access to a 401k, but many people do not take advantage of them. This is often because they do not know what to do with them. Before you just jump right in and start putting money into the account, take a few minutes to carefully plan out your investments.
Know Your Risk Tolerance
Before you can really even get started you need to know how much risk you are willing to take. To do so is pretty easy; you can use one of the many risk profile questionnaires available online. They only take a few minutes to complete, and they will give you the starting point on where you want to invest your money. Equities are riskier than bonds are, so more risk tolerance will mean you want more equities in your portfolio. A general guideline is that the younger you are, the more risk you want to take. Read previous posts on risk tolerance.
The biggest downside to using a 401k is that you do not get to choose what funds are available. Your employer will work with the financial advisor on the plan to come up with a menu of between 20 and 30 fund choices. That menu is what you have to use to pick your investments. If you work for a small company you may be able to talk to your employer about getting new funds added to the mix, but most of the time you have to take what is offered.
When you begin to build your portfolio one of the most important things to look at is how expensive the funds are. Most 401k’s are large enough that they do not have sales charges (if you work for a small company you might want to check to see if there are upfront fees in your plan), but the funds will still have ongoing expenses. As you pick and choose different funds, look them up in the literature provided by your employer. Internal expense ratios will range from .1% for an un-managed fund to 2% for an expensive managed fund. Expense ratios do not exactly determine how well the fund will perform, but many people like to steer clear of the more expensive funds. There have been many debates on whether a managed fund will do better than an un-managed fund (thus justifying the fee).
Expenses are not the only thing that goes into determining if a fund is a good choice or not. You can do as much or as little analysis as you want before you determine if a fund is worth your money. In order to research funds, check out Morningstar or Google Finance. From those sites you can read all about the expenses, 5 year returns, 10 year returns, the fund’s percentile rank in their category, and even some analyst’s opinions. You can spend a few minutes, or a few hours depending on your level of concern.
Target Date Funds
Not everyone wants to worry about fund analysis. You have better things to do, so if you do not have the time to do your own research, take the fund company’s word for it and look at their target date fund selection. Over the last few years these options have gained in popularity since they take a lot of the guesswork out of investing. Simply choose the fund with the date that most closely matches your estimated date of retirement, and it will allocate and rebalance itself as time goes on. The downside is that you are stuck with that allocation, and the expenses tend to be a little higher.
Investment analysis takes practice and patience. Most people have better things to do, and that is why many 401k’s will have an assigned advisor that you can turn to for help. Before you just go in and start investing in whatever fund has the most fun sounding name, brush up a little on what you should be looking for. If you don’t want to take the time, there is nothing wrong with dumping everything in target date funds.
How did you choose your investments?
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