If you're like most Americans, you have a 401(k) that serves as your primary retirement savings vehicle. And while there's no denying the importance of contributing as much to your retirement savings as you can each year, it's equally important that you invest in the best funds for your 401(k) if you want to retire with as much money as possible.
And the best funds to invest in when retirement is still many years away, aren't necessarily the best funds when retirement is just around the corner. Let's take a closer look at five top funds for your 401(k), and the situations that make them ideal.
Owning the right fund for the job at hand
The long-term returns stocks can generate are far superior to the returns you could get from bonds, money markets, or precious metals. The table below gives an excellent visual representation of two low-cost stock index funds, compared to two broad-based bond funds:
As you can see, the stock funds generated vastly superior returns over the long-term. The risk with stocks, however, is in the short-term damage they can cause:
There's a very simple lesson here: Both stocks and bonds are excellent, if used for the proper job. Stocks are the best means of growing your money over the long-term, but can destroy wealth in the short-term. Bonds are a great way to protect your capital from short-term losses while gaining some yield, but would leave you well short of stocks when it comes to long-term growth.
Three stock funds for long-term growth
Vanguard Total Stock Market Index Fund Admiral Shares (NASDAQMUTFUND:VTSAX), Vanguard Small-Cap Growth Index Fund Admiral Shares (NASDAQMUTFUND:VSGAX), and Vanguard Growth Index Fund Admiral Shares (NASDAQMUTFUND:VIGAX) are excellent choices.
To start, the U.S. stock market has averaged around 10% in annualized returns over the past century or so, far superior to other investments when it comes to steady wealth-building. The Vanguard Total Stock Market index fund is an excellent way to capture that potential in a single fund. While there's no guarantee you'll capture 10% in average yearly returns between now and retirement, this fund will let you take advantage of the likelihood that U.S. stocks will continue to be the best way to grow your wealth for the long-term.
The Vanguard Small-Cap Growth Index and Vanguard Growth Index funds can give you even more targeted growth potential. These two CRSP -- the Center for Research in Security Prices -- indexes, the U.S. Small Cap Growth Index and U.S. Large Cap Growth Index, respectively.
While the Total Stock Market Index is comprised of more than 3,590 companies of all kinds and sizes, the Small-Cap Growth Index is made up of 679 small companies that meet certain growth-based criteria, and the U.S. Large Cap Growth Index is comprised of 323 large companies that meet specific growth metrics.
A couple of important points:
- If these exact funds aren't available to you, they can still point you in the direction of similar high-quality funds. Look for similar index-based stock funds that give you broad-based exposure, and at the low expense ratio that helps make index funds generally better investments than actively managed funds. For instance, these three funds sport expense ratios of 0.05%, 0.08% and 0.08% respectively. That's less than $5 per $10,000 invested per year.
- Compare that to far more costly actively managed funds where you pay as much as 20 times more in fees each year. And in addition to being more expensive, 90% of actively managed funds generate worse returns than cheaper index funds.
Stick with index funds, and use the three above as guides to finding the best ones available to you.
Closer to retirement? Two bond funds to protect your nest egg
The Vanguard Total Bond Market Index Fund Admiral Shares (NASDAQMUTFUND:VBTLX) is ideal for money you will need in the next two to five years, while Vanguard Short-Term Government Bond Index Fund Admiral Shares (NASDAQMUTFUND:VSBSX) is an excellent choice for money you're planning to spend in the next couple of years or less. The idea here is that the Total Bond Fund will generally pay a bigger yield, but because rates can fluctuate, the price of the bonds held in this fund can be more volatile, exposing you to potential losses (typically very small) in shorter periods of time.
You're not going to get rich owning shares of these bond funds, which have only generated 8.4% and 1.9% in total returns over the past three years, but you'll also avoid losing a lot of money you were depending on because of a bad few months for the stock market.
For instance, stocks fell sharply over a three month period about a year ago, while these bond funds just plodded along:
Using the right fund will make a huge difference in your retirement
Both stock and bond funds are important to generating -- and then protecting -- your retirement savings. When you're still many years from retirement, investing in the stock funds above will generate far greater long-term returns. But once you start approaching retirement, shifting money you'll need in the next five years or so away from stocks and into the bond funds above will help you avoid big short-term losses that leave you with a lot less money than you were expecting.