How To Invest Your 401(k)

The 401(k) is one of the most popular retirement plans for good reason. It offers a way to save for the future and receive tax benefits — both lowering current taxable income and deferring taxes on investment gains — for doing so. However, the shortcomings of the 401(k) include a limited selection of investment funds and the need to select those funds yourself. If you lack expertise in investing, it may prove to be challenging to maximize your portfolio.

Here’s how to pick investments in your 401(k), including several key things to pay special attention to.

Picking your 401(k) investments

A 401(k) plan will typically offer a range of investments, maybe even a few dozen mutual funds. Some 401(k) plans may also allow you to buy individual stocks, bonds or ETFs. These plans give you the option of managing the portfolio yourself — an option that may be valuable to advanced investors who have a good understanding of the market.

Types of 401(k) investment options

The most common investments offered in 401(k)s include:

• Stock mutual funds: These funds invest in stocks and may have specific themes, such as value stocks or dividend stocks. One popular option here is an S&P 500 index fund, which includes the largest American companies and forms the backbone of many 401(k) portfolios. Passively managed index funds tend to outperform the vast majority of actively managed funds. Not only that, but passive funds are usually much cheaper.
• Bond mutual funds: Bond funds invest exclusively in bonds and may feature specific kinds of bonds, such as intermediate- or short-term, as well as bonds from certain issuers such as the U.S. government or corporations.
• Target-date mutual funds: These funds will invest in stocks and bonds, and they’ll shift their allocations of each based on a specific target date or when you want to retire.
• Stable value funds: These funds invest in low-yield but very safe assets, such as medium-term government bonds, and the returns and principal are insured against loss. These funds are more appropriate for investors near retirement than for younger investors.

Stuck with only abysmal high-cost, low-return investment options in your 401(k) plan? There are alternative retirement investment options, such as an IRA. But IRAs lack one of the key advantages of a 401(k) plan: The potential to get free money from an employer match. The play here is to contribute enough to your workplace plan to get the maximum match and then focus on funding an IRA.

What to look for in a 401(k) investment

For many, the limited selection of funds in a 401(k) may be more of a benefit than a drawback, helping to simplify the process. For experienced investors, a limited fund choice is, well, limiting. These investors might prefer the unlimited selection available in an IRA.

Most 401(k) participants want a good solution (high returns) rather than a perfect solution (the best returns).

To choose the best option, look at two broad factors.

• Long-term returns: These are the returns on the fund over five- and 10-year periods, as well as since inception.
• Expense ratio: Basically, this is the cost to hold the fund for a year as a percent of the money invested in the fund.

All else equal, participants should search for the best returns at the lowest costs. However, be careful about buying any fund that’s had a good recent performance, such as one- or two-year returns, but has delivered a mediocre performance over longer periods. Many investors make the mistake of chasing a hot fund, only to see its performance drop in the future.

If you opt for a target-date fund, you can mostly skip choosing your investments. In this kind of fund, you choose when you need the money — your retirement date, for example — and the fund does the rest. It’s more of a “do it for me” solution, but you’ll likely pay more for the privilege. (Skip to the section below for more details on target-date funds and what advantages they offer.)

How to build a 401(k) portfolio

If you decide to pick investments yourself, you’ll want to keep some important principles in mind to make smarter investments.

Consider your financial goals and time horizon

Your portfolio needs to reflect your financial goals. For example, if you want higher returns, your portfolio likely needs to have more invested in stock funds.

The amount of time you have until you need the money is also a factor. Investors in their 20s and 30s can afford to devote a higher allocation to stocks because there is time to weather market volatility. Someone with less than five years to retirement, however, will want to dial down their exposure to market volatility to ensure the money is in their account when they need it.

Make sure you are properly diversified

Diversification is an important factor, and you’ll want to balance having too much in one type of asset. For example, many experts recommend having an allocation to large stocks such as those in an S&P 500 index as well as an allocation to medium- and small-cap stocks. While stocks often rise (and fall) faster than bonds, bond funds play a more stabilizing influence on a portfolio and generate reliable income, too — valuable in periods of turmoil. A diversified portfolio helps minimize risk and may actually help increase your long-term returns.

Assess your risk tolerance

If you look only at the costs and returns of stock and bond funds, you may end up with a portfolio of only stock funds. You want to have a portfolio that grows but also allows you to sleep at night — that’s called your risk tolerance.

“If you are not that familiar with investing, some plans offer a solution that produces a suggested allocation based upon answering a series of risk tolerance questions,” says Jeffrey Corliss, CFP, managing director and partner with RDM Financial Group at Hightower in Westport, Connecticut.

Adjust your allocation over time

Once you’ve settled on an appropriate investment mix, Corliss recommends checking it annually to see if your portfolio needs to be rebalanced.

“That way your investment allocation will not get too far out of alignment from your desired portfolio,” he says.

Choosing a target-date fund

If you want to manage your own investments, that’s great, but many 401(k) participants would prefer to have someone else do it. While some 401(k) plans may provide some guidance, and even allow you to speak with a financial advisor, many don’t feature this option. In this case, a target-date fund can be an alternative that fills the gap with a professionally created portfolio.

“Target-date funds are investment choices in which the fund family creates an allocation based upon your target retirement date and possibly your risk tolerance,” Corliss says.

As you near the target date, the fund automatically becomes more conservative, shifting away from stocks and toward bonds. “For example, a 2045 target-date fund will be more aggressive and usually have a higher percentage of equities than a 2025 target-date fund,” Corliss says.

While target-date funds may differ somewhat from company to company, they’re generally well-diversified and rebalance automatically.

“For many people, selecting a target-date fund is the ‘safest’ choice and allows for a set-and-forget mentality,” says Morris Armstrong, a registered investment advisor at his own company in Cheshire, Connecticut.

Target-date funds aren’t perfect solutions either, though they do help with creating a diversified portfolio. Participants in a 401(k) plan should still pay special attention to these funds’ expense ratios, which can be much higher than a passively managed index fund.

Another issue is the fund’s allocation to stocks and bonds.

“You should not necessarily choose the date closest to when you want to retire,” Corliss says. “Sometimes the allocation used in that date may be too heavily invested in equities for your particular risk tolerance.”

At the same time, some experts even recommend selecting a target date that’s 10 or 15 years beyond your actual retirement date. The rationale here is that as people are living longer, they need a higher allocation in stocks, which grow faster, to avoid outliving their retirement funds.

Some 401(k) plans may also offer a type of investment called an asset allocation fund, which places investments in asset classes with various allocations to stocks and bonds. The funds might be called aggressive, moderate or conservative. More aggressive funds will have higher allocations to stocks, while more conservative funds will tend to have more bonds.

“Before you invest in these, you need to do your homework and investigate what the allocation is to see if it is suitable to your risk tolerance,” Corliss says.

Potential risks in 401(k) investments

• Being too conservative: Some people may think that the best way to manage risk is not to take any, but being too conservative with your investments can be a risk, too. Many investors don’t allocate enough of their retirement portfolios to stocks, which will likely have the highest returns over the long term. Instead, they stick to assets perceived to be low-risk investments such as bonds. While stocks are volatile, they should be an important part of investing for goals like retirement.
• Paying too much in fees: Fund expenses eat into the return you earn as an investor, so pay special attention to the fees associated with the funds you invest in. If a fund has an annual expense ratio above 0.50 percent, it’s likely you can choose something cheaper. Most index funds cost less than 0.10 percent each year to own.
• Investment losses: This is what most people think of when it comes to investment risk. Stocks and bonds can decline in value, especially over short periods of time. Stocks tend to rise over the long term though, making them ideal assets for goals far in the future like retirement.

Can you lose money in a 401(k)?

It’s possible to lose money in a 401(k), depending on what you’re invested in. The U.S. government does not protect the value of investments in market-based securities such as stocks and bonds. Investments in stock funds, for example, can fluctuate significantly depending on the overall market. But that’s the trade-off for the potentially much higher returns available in stocks.

That said, if you invest in a stable value fund, the fund does not really fluctuate much, and your returns or yield are guaranteed by private insurance against loss. The trade-off is that the returns to stable value funds are much lower, on average, than returns to stock and bond funds over long periods of time.

So it’s key to understand what you’re invested in, and what the potential risks and rewards are.

Bottom line

The world of investing is unfamiliar to many 401(k) participants, so it’s important to learn some of the basics even if you don’t intend on picking funds yourself. Learning about your options can save you a lot of money and even help you make more money.

“Whether you decide to create your own allocation or use one of the pre-designed portfolios, make sure you know what you are investing in,” Corliss says.

Note: Bankrate’s Dayana Yochim contributed to an update of this story.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.