401(k)s give you a lot of advantages in planning for your retirement. Your employer matches some portion of your contributions, and you can borrow from them when it’s absolutely necessary.
But there’s one major disadvantage they have compared to IRAs. Some employers make you choose from a limited set of mutual funds. If you’re not familiar with the funds available to you, it can be difficult to put together a decent strategy for your retirement.
Let’s go over the basics of how to choose mutual funds for your 401(k).
Goals and Risks
Perhaps the most important aspect of how to choose a mutual fund is your goal. How much are you looking to grow your money?
How long do you have before retirement?
And what level of risk are you willing to tolerate?
To some degree, the answer to all three questions should depend on your age.
If you’re younger, and just starting to save for retirement, then you should be very risk-tolerant.
You have decades to grow your money, so you should invest in high-growth assets, even if they come with more risk.
If the market crashes on you, you’ll still have plenty of time to recoup your losses.
However, if you’re a middle-aged investor, then stability should be your main concern. If you’re not that far from retirement, then you’ll need to start withdrawing from your 410(k) soon. That means you want to minimize your exposure to market risk, and pick reliable funds that will grow slowly or maintain their value.
Target-date mutual funds are becoming increasingly popular, and for good reason—they do all the risk-planning for you. You just pick the one with your intended retirement year on it, and voila, you’re allocated correctly.
But if you’d rather choose your risk-tolerance yourself, this table should help.
It’s pretty easy to see the pattern. Younger investors should put their money in funds which will gain rapidly and are a bit more risky. Older investors should put their money in safer funds which will hold their value.
You might have noticed that dividend funds are in both categories. That’s because dividend stocks tend to be very stable companies which pay out their earnings to investors, making them ideal for older folks. However, those dividend payments can be reinvested to buy more shares, which can cause returns to grind exponentially higher over a long period of time. That’s why younger folks find them useful, too.
Another important consideration in choosing mutual funds is how much each one costs.
Mutual fund managers generally extract their pay from investors in two ways. Certain funds charge one-time fees on deposits or withdrawals. Others have expense ratios which are collected as a percentage of the fund’s returns, sort of like a commission. And some have both.
If you’re interested in a fund which charges fees, make sure those fees are less than 6% of the initial investment. If you’re choosing a fund with an expense ratio, it should be under 1%. And funds with both types of costs should have significantly lower numbers than these.
If you’re paying more than a 6% load fee, or a 1% expense ratio, or both, you’re getting ripped off.
Long-Term Track Record
Finally, and perhaps most importantly, you want to look for a fund that consistently does what it says.
Looking at performance over a few quarters or years won’t do. Check out a long-term graph of the mutual fund which covers the entire tenure of the current managers.
If you’re shopping for a fund to grow your money, has it really grown? (If so, don’t be spooked by a few crashes along the way. Recessions happen.) Or if you’re shopping for a fund to protect your money, has it been stable? (Or better yet, has it grown at around the rate of inflation?)
How do the fund’s returns compare with a similar market index? If a high-return fund is significantly underperforming the S&P 500, that’s a red flag. (Though if it’s very close to the index, don’t write it off. Very few mutual funds consistently beat their benchmark index). Similarly, if a stability fund is jumping around a lot more than a U.S. bond index, then it’s not very good at its job.
With all that being said, take the fund’s past performance with a grain of salt—as the old financial cliché goes, it doesn’t predict future returns.
Starting to save for your retirement can be daunting. When setting up a 401(k), you may need to choose from an unfamiliar group of funds. We hope this primer on how to choose mutual funds has given you an idea of what to look for. Your future self will thank you for reading this.
— Samuel Taube
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Source: Investment U