How to Choose the Best Investments for Your 401(k)

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Invest wisely, and you stand a great chance of meeting your financial goals. Image: hikingartist.com via Flickr.

One of the questions I get asked most by friends and family is: "Can you take a look at my retirement plan and tell me what I need to change?"

Based on the sheer number of times I've been asked this question, it's obvious that many people are intimidated by investing and are unsure of how to allocate the money in their 401(k) accounts. However, there are a few easy guidelines that can make those choices much easier.

Spread it out
Most investment funds offered by 401(k) plans are relatively safe and will appreciate over the long run, so there's no single "right" choice. Even the "aggressive" fund options are relatively tame compared to some of the stocks many people buy.

Trying to choose the absolute best funds is not nearly as important as diversifying your holdings. In other words, so long as you have a healthy mix of investments, you should be just fine. If you choose to allocate 70% of your portfolio to stock funds, but all of that money is in one fund, you should consider spreading it out.

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Retirement plans generally have broad index funds, as well as more specialized funds with certain objectives (e.g., aggressive growth, safety and income, or investing in companies of certain sizes). You'll also have at least one choice that invests in foreign stocks.

Basically, you want a few key components in your account. The majority of your account should be in broad index funds that track various types of stocks. Some of your money should also be in fixed-income (bond) funds -- I'll discuss this more later. Finally, you want some exposure to foreign stocks. If the U.S. market starts doing poorly or the U.S. dollar starts to weaken, these could be a great safety net.

So long as those three criteria are met, you can choose whichever individual funds you like. Just as an example, this was my actual allocation in a former 401(k) plan:

Type of Fund Percent of Assets
U.S. stock market index fund 40%
Large-cap equity 15%
Small-cap/mid-cap equity 10%
Foreign stock index fund 25%
U.S. bond index 10%

Notice that the first three funds -- accounting for 65% of my contributions -- were invested in U.S. stocks, with the largest amount in a broad market-tracking fund. There was also substantial exposure to foreign markets. I only had a small bond allocation, as I was only 31 when I left this job and therefore didn't feel the need to invest much in that conservative asset class.

Check out the fees
Assuming you have multiple choices within each of the investment classes I mentioned above, you should also compare the fees that each fund charges.

With mutual funds, like the ones you can choose from in your 401(k), the fees are called "expense ratios." This is the amount the fund charges each year as a percentage of its assets. So a 1% expense ratio means that you pay $1 per year for every $100 you have in the fund. In general, the more actively managed a fund is, the higher the expense ratio. Broad index-tracking funds, such as funds that track the S&P 500, tend to be the cheapest.

And you may be surprised how much the fees vary between funds in the same plan. To illustrate this, here are the fees from the five funds I mentioned in the chart above. Of course, all plans are different, so check out how the fees vary among your plan's offerings.

Fund Expense Ratio
U.S. stock market index fund 0.02%
Large-cap equity 0.39%
Small-cap/mid-cap equity 0.64%
Foreign stock index 0.03%
U.S. bond index 0.05%

While these may seem like rather small differences, over the long run it can really add up. Consider a $10,000 investment in two funds, both of which average 8% annual returns. One fund has a 0.5% expense ratio, and the other has a 0.2% ratio. After 30 years, the small difference in expense ratio means that the cheaper fund will return $7,500 more. Of course, a fund's past performance doesn't always predict how well it will do in the future. Still, don't underestimate the powerful effect of lower fees on your long-term financial health.

Stocks versus bonds
One of the toughest choices for many 401(k) participants is how much of the portfolio should be in fixed-income assets like bonds. The short answer is "not much."

The longer answer is that it depends on how old you are and what your particular retirement goals are. For younger investors (those under 40), a 10% allocation to bonds is generally enough. And even for older investors, no more than half of the portfolio should be in stocks. Once you retire, the appropriate allocation of your assets can change, but so long as you are at least a few years away from retirement, stocks are the best place for most of your money. Bonds are intended to be more of a "safety net" than a wealth creator, and you need to make sure your safety net isn't too big. Otherwise you may find that your nest egg is not enough to retire on.

The bottom line
In a nutshell, there's no single right or wrong way to allocate your 401(k) investments. So long as your money is spread out among several different types of funds and you have the key "safety" components of foreign stocks and fixed-income investments, your 401(k) should be just fine.

The article How to Choose the Best Investments for Your 401(k) originally appeared on Fool.com.

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