You can be clueless about quantum physics, artificial intelligence, or even chemistry and still get by in life. But being clueless about investment decisions is a slightly bigger problem -- that is unless you plan on working for the rest of your life.
Building up a sizable retirement fund requires more than making regular contributions to your 401(k). To grow your retirement savings in a big way, you also need to invest those funds wisely over time. And if you have no idea how to do that, it's time to learn. Here are four steps you can take to make informed decisions about your 401(k) investments.
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1. Choose the right mix
The phrase "asset allocation" refers to the composition of your investments -- or how what percentage of your money is held in equities vs. fixed-income investments. Equities includes stocks and mutual funds that focus on stocks. Fixed-income investments are financial instruments like bonds, bond funds, and money markets that pay a fixed interest rate on a fixed schedule. Because equities and fixed-income investments behave differently, you can manage your overall risk and returns by investing across both categories.
Equities have more upside than fixed-income securities but also more risk. Fixed-income investments provide stable returns but at lower rates than you can expect from equities. By having a mix of both, you can enjoy the growth of stocks while having a stable component in fixed income in your portfolio.
But what is the right mix? It depends on your age, health, and risk tolerance. One conservative formula is known as the rule of 100: Subtract your age from 100, and the result is the percentage of assets you should invest in equities. If you are 35, the rule of 100 tells you to invest 65% in stocks and 35% in fixed income. As you get older, you'd update your portfolio to be more conservative, with higher levels of fixed-income securities.
There's another way to automatically diversify: Your 401(k) may give you the option to invest in target-date funds. These are diversified mutual funds that target a specific retirement year, such as the Vanguard Target Retirement 2050 fund. These funds have a mix of equities and fixed-income securities already and are managed over time to be more conservative as your retirement year approaches.
Target-date funds can be actively managed by a fund manager or passively managed. A passively managed fund follows a set allocation path over time, but doesn't have the overhead of a dedicated fund manager. As such, the passive fund fees are lower.
If you don't want the job of managing your asset allocation over time, a strong target-date fund, active or passive, is a nice alternative.
2. Review fund expense ratios
Let's say you settle on a target allocation of 65% stocks and 35% bonds. Now it's time to pick investments to go into those two buckets. Many 401(k) plans will separate your options by investment category, so it should be clear which are stock/equity funds and which are bond funds.
Start by finding each fund's expense ratio, which measures how much you pay in fund expenses as a percentage of your investment. Fund expenses cut into your returns, so you want the expense ratio to be as low as possible, but definitely below 1%.
A slightly lower expense ratio doesn't automatically mean the fund is better. But large differences in expense ratios can help you weed out funds that are less likely to perform well.
3. Diversify
After eliminating the expensive funds, you're ready to choose from the remaining options. Your asset allocation strategy should provide diversification between equities and fixed income. But you can also diversify within these categories. If your 401(k) allows it, for example, you might invest in large-cap equity funds for stability and small-cap equity funds for growth.
Read through the descriptions, ratings, and strategies of your fund options to understand how each is managed. Prioritize them based on your tolerance for risk. It might feel like guesswork, but if you stick with your asset allocation strategy and pick funds that have low expense ratios, you're already heading in the right direction.
4. Monitor and rebalance
Once you've selected your investments, check-in on their performance every quarter relative to the other options within your plan. Remember to compare equities to other equities and fixed-income to your other fixed-income options. You may decide to make some adjustments if some of your assets are underperforming.
You should also rebalance once or twice annually. Rebalancing means adjusting the composition of your investments back to your intended allocation strategy. In most economic climates, your equities will increase their relative value in your portfolio over time because the price of your stocks appreciated. After a year, you might have 70% equities when you were initially targeting 65%.
Also, as you get older, you'll want to modify your portfolio to be lighter in equities, anyway. Rebalancing annually is your time to make those changes by selling off some investments and using the proceeds to buy others.
This probably isn't as complicated as it sounds. Your 401(k) may have an auto-rebalancing feature, which will make those changes for you at the click of a button. Or if you've invested solely in a target-date fund, you don't have to do anything: That portfolio will rebalance itself automatically.
Contribute, invest, and repeat
You're officially no longer clueless about your 401(k) investments. Don't feel intimidated about making these choices -- it's most important to contribute to your account and then invest in something -- anything other than money market funds. Keep doing those two things and you'll see your nest egg grow over time.
