The problem with giving 401(k) advice is that there is no way for me to know exactly what funds are available in your 401(k) without actually seeing your plan's offerings. For example, it's impossible for me to say that the Dodge & Cox Stock Fund (NASDAQMUTFUND:DODGX), a common 401(k) offering is a smart 401(k) fund for you. If that particular fund isn't offered by your plan, this type of advice would be useless.
Having said that, most 401(k) plans offer the same categories of investment funds. Here are five of these categories, with some popular examples of 401(k) funds that you may want to consider adding to your 401(k) investment strategy.
1. Large-cap equity (stock) funds
These funds invest in the stocks of the largest U.S. companies. Some may passively track a stock index like the S&P 500. The Vanguard S&P 500 Index Fund (NASDAQMUTFUND:VFINX) is a good example of a popular 401(k) offering. These funds typically have low expenses, and are essentially a bet on American business. In fact, Warren Buffett has said that low-cost index funds are the best investment most Americans can make.
Other large-cap stock funds may be actively managed, like the previously mentioned Dodge & Cox Stock Fund. This means that managers actively pick the fund's investments, which naturally comes with higher expenses. However, if the fund's track record justifies the costs, these could be smart options as well.
Regardless of which you choose, large-cap stock funds should be a cornerstone of your retirement account. You can read a primer on asset allocation here, and as a personal example, large-cap stock funds currently make up about 50% of my retirement plan.
2. Small- or mid-cap stock funds
You may notice that some of your fund options are labeled as small- or mid-cap. This simply means that the fund invests in companies that are smaller in size. Simply put, these tend to be more volatile than large-cap stocks, but also offer greater long-term growth potential, so they could be appropriate for a smaller portion of your portfolio. 10% of my account is allocated to a small-cap stock fund. The T. Rowe Price Mid-Cap Growth Fund (NASDAQMUTFUND:RPMGX) is a common example.
It's also worth mentioning that you may see some stock funds labeled as "value" and others as "growth," as you do in the example I just mentioned. This specifies the type of company the fund seeks to invest in. Value stocks are generally defined as companies trading at a discount relative to certain fundamentals, such as their earnings per share. In other words, value funds look for stocks that are undervalued. On the other hand, growth stocks are typically defined as those that are projected to grow earnings at an above-average rate. Fund that invest in both are often referred to as blended or "blend" funds.
Generally speaking, growth stocks are more volatile, but have more reward potential. Value stocks tend to be well-established companies with proven earnings potential, and are therefore considered to be somewhat more conservative.
3. International or global stock funds
There are a few good reasons to get some international exposure in your portfolio. For one thing, foreign stocks can help protect your portfolio from weakness in the U.S. dollar. Also, many international countries, particularly those with developing economies, have high potential for long-term growth.
A few terms you need to know: International stock funds invest exclusively in non-U.S. companies. Global stock funds invest in international and U.S. stocks. And finally, emerging market funds focus on countries with developing economies (think China, Brazil, and India). About 15% of my retirement account is currently allocated to international stocks -- specifically, to an emerging market stock fund. The Dodge & Cox International Stock Fund (NASDAQMUTFUND:DODFX) and the Oppenheimer Developing Markets Fund (NASDAQMUTFUND:ODMAX) are two common 401(k) examples.
4. Fixed-income (bond) funds
As a general rule, subtracting your age from 110 tells you about how much of your retirement assets should be in stocks, with the rest in bonds. I'm 35, and if you notice, I have 75% of my account in the three categories of stock funds I've discussed.
When it comes to bonds, you don't really need to get fancy. I'm of the opinion that a broad bond market fund, such as the Vanguard Total Bond Market Index Fund (NASDAQMUTFUND:VBMFX) is just fine for your bond exposure. If you prefer, an inflation-protected bond fund can also be a smart idea.
5. Target-date funds
The problem with the first four types of funds I mentioned is that you can't just select them and forget about it. Well, you can, but it's not a good idea. Your ideal asset allocation depends on your age, so your mix of funds should change over time. I linked a good discussion of asset allocation earlier, but here's the idea: When you're 35, most of your portfolio should be in stock-based funds with a smaller bond allocation. When you're 65, your portfolio should be much less stock-heavy. And the transition should occur gradually over your working lifetime.
Or, you can choose to invest in a target-date retirement fund (also known as a lifecycle fund) that will do the work for you. Target-date funds invest your money in an age-appropriate mix of stock and bond funds, and gradually shift the allocation from stocks to bonds over the years.
Target-date funds are designed as all-in-one investment options, and are most appropriate for investors who want to worry about their 401(k) as little as possible.
One type of fund to avoid
Many 401(k)s and similar retirement offer cash-equivalent "investment" funds. You might see them labeled as money market funds, or they may have names such as "capital preservation fund."
Whatever they're called, keeping your retirement assets in cash is generally a mistake, especially if you're young. Keeping a cash emergency fund somewhere else is smart, but when it comes to retirement saving, the objective is to allow your 401(k) assets to grow and compound over time.