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Every 401(k) is different, so it's impossible to say which particular mutual funds in your company's plan that are the "best" or "worst" for you. And while a given fund might be great for some investors, it could be terrible for others. However, here are three guidelines that can help you identify the best and worst 401(k) funds for you.
1. Know your investment objectives
Asset allocation is critical when you're trying to set up your 401(k). You can read a thorough description of asset allocation here, but in a nutshell, it means striking the right balance of risk and reward in your portfolio by investing varying amounts of money into stocks, bonds, and cash and equivalents.
Stock funds (also known as equity funds) tend to be relatively volatile, which means they can experience large price swings over short periods of time. However, over long time periods, stocks have a tendency to outperform any other type of asset.
See how the U.S. stock market, as represented by the S&P Total Return Index, has performed over the past year:
There have been some dramatic ups and downs over the past year. If you had to sell some of your shares at any point during that time frame, then you may have suffered a loss. However, over the course of many years, the stock market's returns smooth out:
If you were invested in the broad stock market over the past two decades, then you're sitting on some impressive gains. So if you have the time to ride out any short-term volatility, then the bulk of your portfolio should be invested in stocks.
Bond funds (also known as fixed-income or simply "income" funds) are less volatile, but they don't have the high return potential of stocks. These are more appropriate for older investors who have already built up a nest egg. Once you're close to retirement, your investment priority should shift from growth to preserving your capital and generating income, so bond funds become more appropriate.
As a guideline, I recommend using the "110 rule," which says that if you subtract your current age from 110, that's the percentage of your portfolio that you should invest in stocks. For example, if you're 30, then you should keep about 80% of your 401(k) in stock funds and the other 20% in bonds.
Even if your 401(k) has some fantastic bond funds to choose from, they are actually an extremely unsafe investment if you allocate too much of your money to them, because your portfolio may not grow enough to provide the retirement income you need. Similarly, if you're retired and invest 100% of your money in volatile stock funds, then that could be the worst choice for you.
The bottom line: If you allocate your assets appropriately, then it doesn't matter as much which individual funds you pick.
2. How expensive are your 401(k) funds?
In any financial transaction, you should know how much you're paying in fees, whether we're talking about paying your electric bill or investing in your 401(k).
With investment funds, like those in your 401(k), the fees you pay are expressed as the expense ratio. This number shows you the annual cost of investing in the fund, expressed as a percentage. For example, a 1% expense ratio means that for every $10,000 you have invested in the fund, you'll pay $100 in fees each year.
What constitutes a "normal" expense ratio depends on the type of fund and the size of your 401(k) plan. As a general rule, smaller companies' 401(k) plans tend to have higher fees, while big companies and government organizations tend to have lower fees. However, within the same plan, fees can vary considerably -- even among funds with similar investment objectives. And you might be surprised at how much a slightly lower expense ratio can save you.
Let's say you have the choice between two large-cap stock funds that track the same index. One fund has an expense ratio of 0.75%, while the other charges 0.50%. If you invested $10,000 in each fund, earning an average of 9% per year, then over the course of 30 years the fund with the lower expense ratio would save you $7,700.
This is a simplified example, but it illustrates the importance of looking at your plan's expense ratios and seeing if you can accomplish the same investment objectives for less money.
3. Most people should avoid this type of 401(k) fund
Pretty much every 401(k) plan I've seen has some sort of money market fund. It may have an intriguing name, such as "capital preservation fund." These may sound tempting -- after all, who doesn't want to preserve their capital? However, in the vast majority of cases, none of your money should be allocated to these funds.
To be perfectly clear, a money market fund is one step above keeping cash under your mattress. Money market funds earn minuscule interest rates these days -- much less than 1%. So think of these as keeping your money in cash.
The entire point of your 401(k) is to take advantage of the power of tax-deferred investing to build a retirement nest egg -- with "investing" being the key word. By keeping even, say, 10% of your money in cash, you're robbing yourself of valuable long-term return potential. And the younger you are, the bigger a mistake it is.
If you're already retired, or close to retiring, then it's OK to keep some of your assets in cash equivalents if it makes you feel more comfortable. Even in these cases, however, the majority of your 401(k) funds should be invested, albeit with a larger proportion of bonds than stocks.
The bottom line on choosing 401(k) funds
While I can't tell you exactly which of your 401(k) funds you should choose and which you should avoid, there are a few basic principles that can help you figure it out on your own. As long as you allocate your money properly, pay attention to fees, and keep all of your money invested in stocks or bonds, then you can do an excellent job of choosing your 401(k) funds all by yourself.
