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Hands down, the most common question I get asked by my friends and family is "how should I invest my 401(k)?" Unfortunately, it's impossible to tell you the best funds for your specific 401(k), simply because different 401(k) plans offer different selections of funds. Having said that, with a general understanding about what makes a good mutual fund, you can be well-equipped to decide for yourself.

What to look for

There are three things you should look for when evaluating the investment funds in your 401(k).

  • Low fees – In your plan's literature, this will be listed as the "expense ratio." Basically, this is the percentage of your assets that are used to cover the costs of investing in the fund. For example, if you have $10,000 invested in a fund with an expense ratio of 1%, you'll pay $100 in fees this year. We'll discuss fees more in a minute, but for now just know that lower is generally better.
  • Solid performance history – An investment's past performance doesn't guarantee its future results. Having said that, it's still important to look at this data. For index funds, make sure that the fund's performance matches the stated benchmark. And, for actively managed funds, you'll want to see a track record of performance that meets (or preferably beats) that of peers.
  • Meets your goals – Above all, no matter how low a fund's fees or how strong its performance history is, a fund is only good if it meets your needs. For example, if you're young, most of your portfolio should be in stocks, so even the best bond and money market funds won't meet your needs.

I understand that some of this may seem vague. For instance, what expense ratio should you look for? What kind of performance history is good enough? To clarify these points, we'll look at a few examples a little later on.

Passive vs. active management

There are two main types of mutual funds – passively managed and actively managed. And, no discussion of mutual fund expense ratios would be complete without clarification of the difference.

Passively managed funds simply track an index. For example, a fund that tracks the S&P 500 doesn't require much research and effort from managers. As a result, passively managed funds tend to have relatively low expense ratios. Personally, I like to see passively managed fund expense ratios of 0.25% or less.

On the other hand, actively managed funds have fund managers who choose the stocks and bonds the fund invests in. These fund managers are compensated for their research and expertise; so actively managed funds tend to have higher expense ratios than passively managed ones. For actively managed funds, my rule of thumb is to look for a maximum expense ratio of 1%.

Two good examples

Just to give you an idea of what makes a good 401(k) fund, here are a couple of examples, one passive and one active:

The Vanguard 500 Index Fund (NASDAQMUTFUND: VFINX) is one of the most popular 401(k) funds in the U.S., and for good reason. The fund simply invests in the 500 stocks that make up the S&P 500, which has been a winning investment strategy over long periods of time. Since its inception in 1976, the fund has produced annualized total returns of 10.8%, which is actually slightly ahead of the S&P 500. In fact, Warren Buffett has said several times that the best investment fund choice for most people is a low-cost S&P 500 index fund, and with an expense ratio of 0.16%, it doesn't get much cheaper.

My personal favorite actively managed fund is the Dodge & Cox Stock Fund (NASDAQMUTFUND: DODGX), which is also one of the most popular 401(k) funds. The fund's managers invest in a diverse portfolio of stocks that they perceive to be attractively valued, with the primary goal of producing long-term growth. Just to name a few, the fund's top three holdings are Time Warner Cable, Capital One Financial, and Wells Fargo & Co. And, the expense ratio of 0.52%, while higher than a passively managed fund, is quite reasonable, especially considering that the fund has averaged S&P 500-beating returns since its 1965 inception.

How to tell if your 401(k) funds are no good

The most obvious indication that your 401(k) funds aren't great is if they have excessive fees. It's true that smaller companies' plans tend to have higher fees, but even so, you shouldn't have to pay expense ratios in excess of 1.5% under any circumstances. The median 401(k) expense ratio for small companies is 1.27%, so use this figure as a benchmark for comparing your funds. For a more comprehensive discussion on how to tell if your 401(k) is no good, check out this article.

A word about target-date funds

Most 401(k) plans offer a type of fund that automatically adjusts your stock/bond allocations over time, known as a target-date fund. Target-date funds keep more of your money in stocks when you're younger and gradually shift toward more stable income-producing assets like bonds as you approach retirement.

If you don't want the hassle of choosing individual funds to invest in, and shifting your asset allocation over time, target-date funds can be excellent choices, provided that they meet the criteria discussed earlier -- particularly an expense ratio as low as your other fund choices. This fund from Vanguard is a great example.

The bottom line on 401(k) funds

As long as you choose funds with reasonably low expense ratios that have a good record of performance and meet your investment needs, your 401(k) will take care of itself over time. With a little bit of homework, you can set yourself up for decades of investing success to come.