401k Investment Options

How to Choose the Best Funds

Selecting the right investments within your 401k plan is critical for building a healthy retirement nest egg. Most plans offer a menu of fund choices across various asset classes. Choosing funds strategically based on performance, fees, risk, and diversification best positions your savings for growth over the decades.

This guide will walk through the typical 401k investment options and how to evaluate and select funds to create an optimized portfolio.

Overview of Common 401k Investment Options

401k plans allow participants to direct how contributions get invested across a selection of funds and assets. While the specific fund menu will vary by employer plan, most offer options across these common categories:

Stocks:

• Large Cap Stocks
• Mid Cap Stocks
• Small Cap Stocks
• International Stocks

Bonds:

• Investment Grade Bonds
• High Yield Bonds
• International Bonds

Cash:

• Stable Value / Money Market

Target Date Funds:

• Target Date Retirement Funds

Balanced/Asset Allocation:

• Conservative Allocation
• Moderate Allocation
• Aggressive Allocation

Specialty:

• Real Estate
• Commodities

Company Stock

Gaining a grasp of the core risk profiles and objectives of these major asset classes allows for more informed selection.

How 401k Plans Work

Before diving into fund selection, it helps to understand some 401k basics:

• 401k plans allow contributing pre-tax or post-tax (Roth) earnings toward retirement
• Contribution limits for 2023 are $22,500 plus a $7,500 catch-up for those 50+
• Some employers match contributions up to a certain percentage
• Funds grow tax-deferred and are taxed at withdrawal
• 10% early withdrawal penalty applies if accessed before age 59.5
• Loans or hardship withdrawals are available from some plans
• Required minimum distributions (RMDs) start at age 72 to force taxable income
• 401k balances can be rolled over to IRAs or new employer plans when leaving jobs

Take advantage of the 401k’s tax perks and any employer match to significantly grow long-term savings.

Asset Allocation Fundamentals

Asset allocation involves dividing investments across various asset classes and categories that perform differently under different market conditions.

The core goal is constructing a diversified portfolio with a prudent mix of equities, fixed income, and other assets tailored to meet your risk appetite, time horizon, and financial situation.

These principles provide a framework for choosing 401k funds:

• Risk tolerance – Ability to accept volatility determines allocation to volatile assets like stocks.
• Time horizon – Those with longer timeframes until retirement can accept more risk and volatility.
• Age – Younger investors can allocate more to stocks while those nearing retirement may favor bonds and cash to preserve capital.
• Other savings – Larger balances in non-retirement accounts allow a more aggressive 401k strategy.
• Goals – Desired retirement lifestyle and account balance factors into required long-term returns.

Your ideal asset allocation will evolve over time from more aggressive to conservative as your life and financial situation changes. 401k funds should be reviewed periodically and adjusted.

Evaluating 401k Fund Options

Use these criteria when analyzing the available fund options in your employer’s 401k plan:

Historical Returns

• Compare 1-year, 3-year, 5-year, and 10-year annualized returns to similar fund categories and benchmarks. Consistently delivering above average returns signals an ability to outperform peers.

Fees

• Lower expense ratios put more of your money to work. Index funds offer ultra-low fees. Actively managed funds tend to be pricier.

Risk Metrics

• Standard deviation shows volatility. The Sharpe ratio divides return by volatility to measure risk-adjusted return. Higher scores are better.

Fund Manager Tenure

• Longer manager tenure lowers risks of abrupt strategy changes or underperformance tied to portfolio manager turnover.

Fund Size

• Bigger funds have lower liquidity risks and wider diversification. But size can limit nimbleness.

Performance Consistency

• Smooth year-to-year returns signal steadiness across different market environments. Spiky rollercoaster returns increase risk.

Diversify across funds exhibiting positive fund criteria optimized for your preferences and goals.

401k Investment Strategies

Utilize these portfolio construction approaches to choose an optimized set of 401k funds:

Passive Index Investing

Construct a portfolio solely from low-cost index funds tracking major market segments. This hands-off strategy provides broad diversification and market-matching returns on autopilot.

Target Date Fund

Select a single target date retirement fund matched to your estimated retirement year. The fund automatically handles asset allocation, rebalancing, and adjusting to a more conservative glide path over time.

Active Tactical

Allocate across actively managed funds aimed at outperforming benchmarks through tactics like security selection and tactical asset allocation shifts. Requires confidence in fund managers’ ability to beat the market.

Core and Satellite

Blend passive index funds as the core portfolio foundation supplemented by actively managed funds as potential outperforming satellites. This balances costs, diversification, and pursuit of excess gains.

ESG Investing

For those wishing to invest according to environmental, social, and governance values, look for ESG designated funds or those specifically avoiding certain sectors like fossil fuels or firearms.

Choose the strategy that best aligns with your preferences, complexity tolerance, confidence in active managers, and ability to rebalance.

Common 401k Investment Mistakes

Some missteps to avoid with your 401k fund selections:

• Chasing past performance – Don’t select recent top performers. Past returns don’t guarantee future gains.
• Taking on too much risk – Portfolios overexposed to volatile assets face increased likelihood of heavy losses during downturns.
• Being overly conservative – Allocating too little to stocks can hamper the ability to achieve long-term growth.
• High fees – Excessive fund expense ratios act as a drag on investment balances over time.
• Lack of rebalancing – Fail to realign allocations as some assets outperform. Portfolios drift from target as a result.
• Portfolio gaps – Ensure your funds provide exposure across major asset classes so no category is neglected.
• Company stock concentration – Avoid excessive exposure to employer stock which adds uncompensated risk.

Stick to proven principles of prudent asset allocation, diversification, and avoiding unnecessary costs.

Choosing 401k Funds for Different Goals

Align your 401k fund selections with specific financial situations and retirement timelines:

New or Young Employee (<30)

• Aggressive stock exposure up to 90% is appropriate with decades until retirement
• Small cap and emerging markets provide higher growth
• Minimal bonds, cash needed
• Maximum risk tolerance
• Low costs key as balances are smaller

Mid-Career (30-50)

• Scale back stock exposure to 70-80% range
• Introduce short-term bonds, TIPS, and cash positions
• Low costs still important with larger balances
• Monitor and adjust allocation every 3-5 years
• Increase diversification

Approaching Retirement (50+)

• Raise fixed income and cash to 30-40% to preserve capital
• Emphasize stable value assets and principal protection
• Begin to simplify and consolidate fund holdings
• Assess tax-efficiency of funds
• Review minimum required distribution options

High Net Worth / Large Balance

• Broaden diversification into alternative assets like REITs, commodities, and TIPS
• Access to institutional share class funds with lower fees
• Higher contribution limits allow faster capital compounding
• Consult professional financial advisor on complex strategy

Remember, what matters most is not chasing hot trends but constructing a resilient portfolio aligned with your situation.

Best Practices for Managing 401k Investments

Follow these tips for ongoing success with your 401k fund portfolio:

• Review holdings at least annually or when life changes occur
• Rebalance to realign with target asset allocation if drift exceeds 5%
• Resist panic selling during market declines
• Treat contributions as long-term investments, not short-term trading
• Consolidate to your best 1-4 fund ideas per asset class
• Check vesting status on employer matches if leaving the company
• Compare plans and fund choices if starting a new job
• Take advantage of in-service withdrawals or loans only as a last resort
• Don’t ignore old 401k plans – consolidate or transfer to an IRA

Proactively managing your 401k investments leads to a healthier nest egg over the decades. Small improvements made early compound into very meaningful impacts later as contributions and earnings snowball.

Wrapping Up

The freedom and responsibility involved with directing your own 401k investments can seem daunting as a beginner. But learning the major fund options and staying true to sound asset allocation principles over time goes a long way.

Max out contributions early and often, choose low-cost diversified funds aligned with your strategy, avoid reacting emotionally to market swings, and revisit allocations periodically.

This simple yet powerful process allows your 401k balance to smoothly compound over the decades into a sizable sum that provides the retirement lifestyle you desire.