Selecting investments in your 401(k) can be a daunting task. Many people have 401(k) plans through their employer, yet very few of them have ever received education or recommendations on how to invest within their retirement account. Although retirement accounts are a great tax saving vehicle, it is important that you take an active role in managing your 401(k) to be sure you are setting yourself up for retirement success.
Many times, 401(k)’s will offer a limited number of investment options. Some companies will offer employer stock in additional to a handful of mutual funds. Other 401(k)’s have a brokerage link option, which allows you to invest in almost any mutual fund in the market. You will have to talk with your HR department to determine your options.
Here are some dos and don’ts to help get you started:
Don’t invest in company stock
I do not recommend investing in company stock through your 401(k) (or in any other account for that matter). Why? For most people, their greatest asset is their ability to earn money. This means your greatest asset is reliant upon your company. Investing in company stock is simply putting too many eggs in the same basket. If your company fails, you will lose your job. This is bad enough without having to worry that your retirement account just lost all of its value. When in doubt, just think Enron.
Don’t select every investment option
I frequently see clients select every investment option in their 401(k). Clients will put 10% of their account into each of the 10 funds offered by the 401(k). The reason this is a bad idea is because the funds aren’t necessarily diversified. If 8 of the 10 mutual funds are 100% stock funds, then you may have way too much stock in your portfolio and not be properly diversified.
Do look at the expense ratios
Mutual funds charge an expense ratio which is effectively a management fee. Although the management fee is necessary for the mutual fund to operate, fees vary greatly between funds. Expense ratios directly lowers your returns, however you won’t see these fees come out of your account because they are deducted directly by the mutual fund. I like to see expense ratios under .4%, and even lower if possible. Stay away from the actively managed funds, as these will carry fees of 1% or even more. Remember, a 1% fee means 1% less in return for you.
Do select index funds
Most 401(k)’s these days give access to index funds. Many times these are Vanguard funds, however they can certainly be from other companies. Index funds will usually have an index such as the S&P 500 or MSCI EAFE (International stocks) in the name of the fund. These will almost always have the lowest expense ratios, so that is another way to spot an index fund. If index funds are not an option, a target dated fund may be the next best thing. I’m not the biggest fan of them, but sometimes it is the best you can do!
Do consult an investment advisor
I wish it was easy enough to invest in 401(k)’s without needing an investment advisor, but there are a lot of pitfalls you need to be wary of. Consulting an investment advisor will help ensure you are properly diversified, not only in your 401(k), but in your portfolio as a whole. Some investment advisors now charge by the hour for investment recommendations in a 401(k), so it can be a very cost effective way to be sure you are on the right path for retirement.
So what do you think? How do you currently make investment decisions in your 401(k)? Does this help clarify how to invest in your 401(k)? Feel free to share in the comments section!
Alan Moore is a fee-only financial planner and founder of Serenity Financial Consulting in Shorewood WI. Follow him on Twitter @R_Alan_Moore. You can contact him at alan@serenityfc.com, 414-455-5313, or visit his website at www.SerenityFC.com. Want more education? Download your free guide to the “10 Easy Steps To Securing Your Financial Future Today.”
Does your comment “Don’t invest in company stock” refer to stock in the company you work for, not all company stock? The flip side is that while there are Enron’s about to tank, there are also Google’s about to rocket. The trick is knowing which is which. Some 401(k) plans increase their matching contribution when buying company stock, or sell the stock at a discount and it’s hard to turn down free money. I think better “all purpose” advice is to stay diversified. Never put more than (you pick the %) of your money in any single company’s stock, including your employer’s. Watch the expenses is great advice. By the way, Mr. Moore, what is your management fee and is that on top of mutual fund, ETF, etc. fees? Buying index funds has certainly worked for me. In fact, if you’re sort of lazy, I suggest a couple of big index ETFs (e.g. SPY, IWM) and rebalance once a year. Don’t forget to convert to cash when a big expense is coming up, like paying for your kid’s college. Finally, get educated! There are several Milwaukee based investment education groups. I’d stay clear of “stock clubs” where you all throw in a few bucks and buy something as a group. The paperwork is a hassle, strong personalities sometimes bully out good advice and you might end up getting cheated by someone you thought was a friend. Better to stick with a pro who you can throw in jail without feeling bad.
Pennypacker, I don’t think I’m insane! You are correct that employees of Apple and Google have done well if invested in company stock, but it is just too big of a gamble. Hindsight is 20/20, and it is easy to look back and say if a decision was correct or incorrect. I don’t have a crystal ball, so I wouldn’t bet my clients ability to achieve financial independence on the actions of a single company.
The standard comeback to "I could point to 10 success stories for every Enron" is that the failures just quietly disappear, taking your money with them. The financial press is more interested in hyping a go-go stock (showing my age there) because people like to think that's the one they will pick. Again, unless you are willing to take on a lot of risk (and risk is no guarantee of reward), diversify. In any event, remove emotion, which is hard to do with your own employer's stock.
If you are getting a discount to purchase (or have stock options) then you may be the exception. For example, if you can purchase your company’s stock at a 10% discount but are required to hold it for 2 years before selling, my rule of thumb would be to buy the stock as long as it represents less than, say, 10% of your overall portfolio. And after 2 years, sell it in order to get more diversified. There will always be success stories such as Apple and Google, and we want to believe that our company will provide the same type of growth and opportunity. I don't want my clients betting their ability to achieve financial independence on it. I apologize for the “company stock” confusion. I have been referring to the company that you work for, but again, it goes for all individual stocks really. And North Shore Newbie, ESPP's are certainly an exception in terms of the way they operate and how it fits into a portfolio.