Most large and many medium-sized companies offer their employees a 401(k) retirement plan. These plans come with a number of benefits, often including a matching contribution from your employer, which makes them well worth contributing to. In many ways, the 401(k) is the best way for most people to build up a retirement nest egg with the best return for the money contributed.
But one of the challenges is knowing which funds at your disposal you should contribute to. After all, the kinds of returns you can expect can vary greatly from one fund to the next, as well as the short-term risk of losses, and a litany of things that must be considered based on your age, your other retirement savings, and how many years you have before you plan to retire and start taking money out.
With that in mind, let's discuss the most important things everyone should consider to make sure they choose the best funds in their 401(k).
Different kinds of funds
In general, there are three different kinds of funds you should be able to choose from.
Stock funds are the best tool for long-term growth. If you're still decades away from retirement, the vast majority of your 401(k) dollars should be invested in stocks or stock-based funds. Stock funds are also the most volatile, meaning their value can swing up and down far more than either bonds or cash. This volatility can create risk when you're close to needing to tap your 401(k) in retirement. This is why, in general terms the closer you get to retirement, the more of your 401(k) you'd want to shift away from stock funds and into bond and cash funds.
Bond funds are generally solid ways to get some return through the interest paid, while limiting the risk of short-term capital losses. This can be ideal for retirees and near-retirees, for the portion of their portfolio they expect to withdraw within the next several years. However, the trade-off for being less volatile than stocks is reduced rates of return over the long-term. For instance, stocks have averaged almost 10% per year historically, while high-quality bonds have generated less than half of that. Today's bonds generate even less.
Cash funds can include categories such as money markets and generally only make sense for the very shortest of periods -- for instance, money you plan to either withdraw within a year. The obvious benefit here is very stable value, but at the cost of very low returns, especially at current interest rates. In reality, cash will almost certainly lose spending power to inflation, so this isn't a fund to use for the long-term.
The big takeaway here: Different fund categories are like tools. You choose the proper tool for the job at hand.
Index-based stock funds should be the foundation for most people
In general terms, stock funds should make up the majority of holdings for most people, especially workers who are still decades away from retirement. Even if you're nearing retirement, it's probably not a good idea to move your entire 401(k) into bond funds, for example. Most people who make it to age 65 -- both men and women -- will live to age 80, and many will live longer than that. For that reason, even retirees should have a portion of their retirement savings invested in stocks for growth.
And in general terms, the best stock funds to own are low-cost index funds. A favorite category are funds that track the S&P 500 index, such as the Vanguard 500 Index Fund Admiral Class (NASDAQMUTFUND:VFIA.X). This fund is ultra-inexpensive, with an expense ratio of 0.04% -- that's only $4 per year for each $10,000 invested in the fund. As a comparison, many actively managed mutual funds charge 1% per year or even more -- that's $96 per year more in fees. The kicker? More than 90% of large cap actively managed funds underperform the S&P 500. So you pay a premium for lower returns.
Your 401(k) may not offer the Vanguard fund, but there's a good chance it does offer a similar S&P 500 index fund. This category of funds can make for a solid foundation for most people's 401(k). How good a foundation? Even superinvestor Warren Buffett says an S&P 500 index fund is the ideal investment tool for most people.
What about stocks?
The reality is, very few 401(k) plans allow for the buying of individual stocks. However, if your employer supports this approach through a directed investment or brokerage option, that's fantastic! After all, The Motley Fool exists as a platform to help people invest better, and stocks are the best tool to build long-term wealth. Furthermore, if you're willing to dedicate the time and effort to find the best companies to buy, you can do even better than the S&P 500. It's hard, but Motley Fool founders Tom and David Gardner have steadily proved for the past quarter-century that individual investors can beat the market.