The Worst Funds for Your 401(k)

The most common investment question I get asked by friends and family by far is: "Can you take a look at my 401(k) and tell me what investments to choose?" While I'm always happy to oblige, the secret is that choosing your own 401(k) funds doesn't need to be complicated -- as long as you know how to identify and avoid your plan's worst investment funds.

High fees are the enemy to long-term gains

Your 401(k) allows you to choose which mutual funds you'd like to allocate your investments to, generally as a percentage of your contributions. Here's the golden rule: When you invest in mutual funds, fees are the enemy.

Image source: Getty Images.

When examining your 401(k) plan's literature, the fees you pay on your investments will be listed as the "expense ratio" for each fund. This is the fee you'll pay each year, expressed as a percentage of your investment's value. So, if you have $10,000 invested in a fund with a 1% expense ratio, you'll pay $100 in management fees to the mutual fund company.

And, these fees can make a big difference in your investment performance over long periods of time. For example, a $10,000 investment in the S&P 500 made 30 years ago would be worth approximately $152,000 today. However, if you had invested that same $10,000 in a mutual fund with a 0.5% expense ratio and the fund's investments matched the market's performance, your final value would be $132,000 -- a $20,000 difference because of a "tiny" 0.5% fee.

As a personal example, I participate in a 457(b) plan (like a 401(k), but more common among government employers) for a part-time teaching job at my local community college. Let's say that I want to allocate some of my money to stock-based funds. My plan offers three fund options that focus on large-cap U.S. stocks:

Data source: South Carolina PEBA.

Now, I'm not calling either of the first two funds "bad" investment options. In fact, the Dodge & Cox Stock Fund is a personal favorite of mine, and has a long history of outperforming the market. And all three of these options are far cheaper than the average U.S. stock mutual fund's expense ratio of about 1.25%.

However, notice that there is a 65-basis-point difference in gross expense ratio between the highest- and lowest-cost funds on the list, so it's important to take a look at each fund's historical performance to see if the higher fee is justified. In most cases, the answer will be no, as more than 80% of actively managed funds regularly underperform broad-based stock indexes that you can invest in for practically nothing. The Vanguard Institutional Index fund in the chart simply tracks the S&P 500's performance, and its 0.02% expense ratio is the lowest I've ever heard of from any fund of any type. (Note: To be clear, just because a fund outperformed or underperformed the market in the past doesn't necessarily mean it will continue to do so.)

To borrow a quote from billionaire investor Warren Buffett's recent annual letter to Berkshire Hathaway shareholders, "When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients."

Make sure your 401(k) funds meet your investment objectives

The second point I'd like to make is that any 401(k) fund, or combination of funds, is a bad option for certain groups of people. For example, a fund that's 100% invested in small-cap stocks is generally a bad idea for an 80-year-old who relies on his or her nest egg to generate income and isn't worried about long-term growth.

So, in addition to being aware of how investment fees work, it's important to have a basic knowledge of asset allocation as well.

Here are the general concepts you should know:

• Stocks are relatively volatile, but have the potential for excellent long-term returns.
• Bonds, or fixed-income investments, are less volatile, but are designed to produce income rather than great long-term performance.
• Cash investments (such as a money market fund) are 100% safe, but will also earn next to nothing.

Generally speaking, while you're young, most of your money should be in stocks, and as you get older, you should gradually increase your allocation to fixed-income investments.

Even though they're safe, money market funds and other cash instruments should generally be avoided, unless you're already well into your retirement. These funds may even have enticing names such as "capital preservation fund," but I consider them to the one of the biggest 401(k) mistakes most people can make.

One good rule of thumb is to subtract your age from 110 to find the percentage of your 401(k) that should be in stock (equity) funds, and the rest should be in bond (fixed-income) investments. For example, I'm 35, so this means I should have 75% of my 401(k) in stocks and 25% in bonds.

Here's a more complete -- but quick -- discussion of asset allocation that can tell you everything you need to know to choose the mix of 401(k) investments that meets your needs.

The bottom line on 401(k) funds

Without actually seeing which funds are offered by your 401(k), there's no way for me to tell you which are the worst and which are the best. However, by following the principles outlined here, you should be able to spot the best funds to meet your long-term investing goals, and successfully avoid the worst ones.