A 401(k) plan is a great way to save and invest for retirement and should be part of anyone's financial plan if it's offered through an employer. However, it's not without its limitations. To maximize your 401(k), investors should consider ditching this investment option.
A 401(k) can get costly
One of the downsides of a 401(k) plan is the limited investment options. Unlike regular brokerage accounts and IRAs, you can't purchase any stock or exchange-traded fund you want in your 401(k) plan; you're given options by your plan provider. For many 401(k) plans, these options include your company's stock, funds based on market cap, and target date funds. As you get closer to retirement, target date funds reallocate to become more conservative and focus on capital preservation instead of growth. Unfortunately, they are generally more expensive because they're actively managed.
The average expense ratio of a target date fund is 0.52%, meaning you'll pay $5.20 annually per $1,000 you have invested in the fund. You can save yourself lots of money in the long run if you avoid target date funds and instead just invest in the funds that your target date fund likely holds, cutting out the middleman. It will require more work -- although not much since you would likely only have to adjust your allocations every few years (depending on your risk tolerance) -- but you can easily justify the time when you consider how much money you could potentially save.
There's a cheaper route
Instead of relying on a target date fund, you might be able to build your own solid 401(k) portfolio if you break it down into four smaller funds: Large-cap, mid-cap, small-cap, and international. Large-cap funds should be the bulk of your portfolio because they're more stable and invest in bigger and more well-established companies that are likely to be less volatile. But you still want to give yourself a chance for growth, though, which is where smaller and mid-sized companies come into the equation.
Investing in small-cap companies through funds is largely about giving yourself the chance to experience exponential growth because as companies grow, the chance for such hypergrowth becomes limited. However, with this chance for exponential growth comes more risk. Small companies are more likely to experience high volatility and fall victim to broader economic conditions. Mid-cap companies are a good middle ground; they're small enough to have high growth potential, but large enough to be more stable during tougher economic times.
To round off your selections, include an international fund. Only investing in U.S. companies is limiting and you take away a chance to invest in solid international companies. Since it'll be a fund, it would likely get you exposure to companies in both emerging markets and developed markets, both of which have good growth potential.
How to break down the investments
How much you should allocate to each fund depends on your age and how much time you have until retirement. The further you are from retirement, the more you can have allocated to the small-cap and mid-cap funds because you have more time for growth and to bounce back from market downturns. One example of the breakdown for someone in their 30s may look like this:
- Large-cap: 60%.
- Mid-cap: 10%.
- Small-cap: 10%.
- International: 20%.
As time goes by, you would ideally contribute less to the mid-cap and small-cap funds and reallocate that money into the large-cap and international funds (with large caps taking priority).