How to Pick Investments for Your 401(k)

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You’ve set yourself up for retirement success by enrolling in your employer-sponsored 401(k) plan. Good job, you!

Now it’s time to pick investments for your 401(k), which can feel like trying to choose between all 31 flavors of ice cream. But don’t fret, choosing your 401(k) investments is actually easier than it sounds. This guide will walk you through how to pick investments for your 401(k).

First, know that more important than where you invest is that you are investing. You don’t need to pick the perfect fund; you just need one (or ones) that will let you start investing your retirement savings. You can always change where you invest, but you can’t get back the years of growth you miss by not investing at all.

How to pick investments for your 401(k):

— For the one-fund, set-it-and-forget-it approach, use target-date funds.

— For a one-fund, don’t-forget-it-forever strategy, use target-risk mutual funds.

— For a simplified DIY portfolio, use the three-fund approach.

Step One: Determine Your Allocation

Asset allocation is the proportion of stocks, bonds and other investments you have in your portfolio. The reason allocation is so important is that it determines the risk level of your portfolio.

There are two ways to look at risk when investing: how much risk you need to take to get the return you want on your investments (more risk equals more potential long-term return), or how much risk you can tolerate without wanting to get off the roller coaster.

[See: 10 Investing Tips for Busy People.]

In general, the longer your time horizon, the more risk you can afford to take. If you have 25 or more years to retirement, you can hold more stocks to maximize your portfolio’s long-term growth potential. But if market volatility prompts you to sell prematurely, there’s no point in using an aggressive portfolio even if you want that level of return.

If you’re the type of person who knows the market will go up and down and you’re not going to worry about it, you can tolerate risk, says Chad Parks, founder and CEO of Ubiquity Retirement + Savings. But if you’re the type of person who worries about your investments and wants to check on them every day like a new mother making sure her sleeping baby is still breathing, you’re better off investing more conservatively.

No matter how risk-loving you are, as you near retirement you should scale back your aggressiveness to protect your portfolio from potentially disabling losses just when you’re about to start withdrawing. With this in mind, a person’s 401(k) asset allocation could look like this over time:

A Sample 401(k) Investment Strategy

Years to Retirement U.S. Stocks International Stocks Bonds Cash or Short-term Funds

25+

55% 40%

5%

0%

15-24

55% 35%

10%

0%

10-14

50%

35%

15%

0%

5-9

50% 30%

20%

0%

1-4

40%

20%

30%

10%

Please keep in mind this is a very general allocation plan. The closer you get to retirement, the more important tailoring your investing strategy to your personal situation becomes.

Step Two: Pick the Investments for Your 401(k)

Once you decide how much you want to invest in stocks versus bonds, you can pick the 401(k) investments to create your desired portfolio. Naturally your investment options will be limited to the funds available in your plan, but if they’re available, the following are all good options.

The one-fund, set-it-and-forget it approach. Target-date funds were designed with 401(k) investors in mind. These funds become gradually more conservative as they near their retirement date target. Simply choose the fund that corresponds with your retirement year and the fund manager will take care of the rest.

[See: Build Your Investment Strategy With These 9 Questions.]

Mike Lynch, vice president of Strategic Markets for Hartford Funds, is a “big fan” of target-date funds for folks who just want to set-up-and-forget their 401(k) — at least in the beginning. As you near retirement, consider adding other funds or replacing your target-date fund with a more individualized investment strategy, he says.

The one-fund, don’t-forget-it-forever strategy. Target-risk mutual funds, also called asset allocation funds, are designed around a target asset allocation instead of a retirement date. A 60/40 fund will maintain a 60% stock to 40% bond exposure indefinitely.

“What’s great about these funds is someone is constantly monitoring them to keep the allocation consistent,” Lynch says. In other words, you don’t need to worry about rebalancing because the fund does it for you.

The caveat is that since the fund won’t change its allocation, if your situation changes, you’ll need to find another fund or add funds to counterbalance it. Your asset allocation fund won’t become more conservative as you near retirement, so you’ll want to switch to a more conservative target risk fund later or add a bond fund to your portfolio to reduce your overall risk.

The simplified DIY portfolio. If you want to have your hands closer to the steering wheel in your 401(k), you can always design your own portfolio from the various 401(k) investments available. The trick here is finding the right funds to match your goals.

One investing strategy is the three-fund approach: Use a U.S. total stock market index fund, an international total stock market index fund and a U.S. total bond market index fund. Each of these asset classes are distinct enough that they won’t all be up or all down together. Translation: You’ll be diversified.

If you want to diversify even further, you could add a real estate, commodities or alternative fund to the mix.

[See: 8 Investing Do’s and Don’ts During Market Volatility.]

To find the index funds in your 401(k) investment options, sort the available funds by expense ratio (this is the amount of your investment that will go toward paying fund costs) from lowest to highest. The cheapest funds will most likely be your index funds. Pick one fund for each category — remember, it doesn’t have to be the perfect fund; if you have more than one option just choose the cheapest one — and use the allocation you chose in step one to determine how much to invest in each fund.

You can adjust how aggressive your portfolio is by tweaking the percent you invest in each fund. Dial up risk by increasing your stock exposure or dial it down with more bonds. With only three funds to juggle, you can still tailor your risk without giving yourself a headache when it comes time to rebalance, which you should do every six months to a year.

Step Three: Keep Costs Low

Whichever 401(k) investment approach you use, aim to keep the expense ratio of your funds as low as possible. You can’t control how well your investments perform, but you can control how much you pay in fees. Parks recommends keeping the expense ratio on your 401(k) investments below 0.5%.

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How to Pick Investments for Your 401(k) originally appeared on usnews.com