The Best Funds for Your 401(k)

By Matthew Frankel Markets Fool.com

Let me state right from the top that without knowing your 401(k) plan and its fund offerings, there's no way for me to tell you exactly which funds are the best for you. However, there are some principles that apply to all 401(k)s that you can use to choose your plan's best funds and create the ideal retirement savings plan for you.

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It's all about the fees

When it comes to long-term investing, fees are the enemy. All other factors being equal, seemingly small investment fees can take a big bite out of your long-term performance.

Image source: Getty Images.

Consider this simplified example. The S&P 500 has generated total returns of about 9.5%, on average, throughout the past 100 years or so. If you invest $5,000 per year and achieve this rate of return, you'll have a $748,000 nest egg after 30 years. However, if you invest in a fund that charges a 1% annual fee (also known as the expense ratio in your fund's literature), it will reduce your 30-year account value to $621,000. Still impressive, but that "little" 1% fee robs $127,000 of your long-term gains. That can make a serious difference in your quality of living after retirement.

Now, all of your 401(k) funds will have fees, but one smart thing you can do is compare the fees of the funds that essentially accomplish the same objective. For example, if one large-cap growth stock fund has a 1% expense ratio, and another charges just 0.5%, the second could save you lots of money over the long run, unless there is some other compelling reason to choose the first one.

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Make sure your 401(k) funds meet your needs

Perhaps the most important concept you can learn in regard to your 401(k) and other retirement savings is basic asset allocation. In a nutshell, this means determining the right combination of stock-based funds and fixed-income (bond) funds.

Generally speaking, stock-based funds (your 401(k) may call these "equity" funds) have the highest growth potential. The trade-off is that they tend to be rather volatile. Therefore, stock funds are most appropriate for savings that you won't need for several years, to give your investments adequate time to ride out any ups and downs in the market.

On the other hand, fixed-income, or bond, funds are designed to produce consistent income without too much risk. The downside is that the long-term growth potential is significantly less than you can expect from stocks.

Within each of these broad categories, there are several levels of volatility and return potential. As far as stock-based funds go, here are a few basic concepts:

  • Growth stocks are generally more volatile than value stocks but have higher long-term growth potential.
  • Similarly, small-cap stocks are more volatile than large-cap or mid-cap stocks.
  • Foreign stock funds by themselves are typically more volatile than U.S. stocks but can add diversification to your 401(k) in relatively small proportions.

With fixed-income funds, there are also a few rules of thumb to keep in mind:

  • Corporate bonds typically produce higher returns than government (also known as municipal or Treasury) bonds.
  • Long-term bond funds produce more income but also are more volatile in terms of price, as opposed to short-term or intermediate bonds.

One popular rule to determine your basic asset allocation is known as the "110 rule." Subtract your age from 110 to determine the approximate percentage of your portfolio that should be invested in stocks, and the remainder should be in bonds. For example, I'm 35, so that means 75% of my 401(k) should be in stock funds, with the other 25% in bond funds, and significant diversification within each category.

Here's what I do

In my personal retirement plan, I follow the 110 rule. I split my 75% stock allocation among three different stock funds (large-cap stock, small-cap value, international stock) and my 25% bond allocation between two different funds (total bond market and short term government securities). There's no way for me to know if any of these are available in your retirement plan, or if they are, whether they have low fees.

However, the point is that getting the stock/bond split right and choosing funds with reasonable fees are the two most important factors. If you can get these two concepts right, you'll be well positioned to set up an investment plan that meets your long-term retirement planning needs.

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