How to invest your 401(K)
Nothing is more central to your retirement plan than your 401(k). It represents the largest chunk of most retirement nest eggs.
聽is just step one. Step two is investing it, and that鈥檚 one place where people get tripped up: According to a 2014聽, more than half of 401(k) plan owners wish it were easier to choose the right investments.
Here鈥檚 what you need to know about investing your 401(k):
Come to terms with risk
Some people think investing is too risky, but the risk is actually in holding cash. That鈥檚 right: You鈥檒l lose money if you聽诲辞苍鈥檛聽invest your retirement savings.
Let鈥檚 say you have $10,000. Uninvested, it could be worth less than half that in 30 years, factoring in inflation. But invest it in your 401(k) at a 7% return, and you鈥檒l have over $75,000 by the time you retire 鈥� and that鈥檚 with no further contributions.
Clearly you鈥檙e better off putting your cash to work. But how?
The answer is a careful asset allocation, the process of deciding where your money will be invested. Asset allocation spreads out risk. Stocks 鈥� often called equities 鈥� are the riskiest way to invest; bonds and other fixed-income investments are the least risky. Just as you wouldn鈥檛 park your life savings in cash, you wouldn鈥檛 bet it all on a spectacular return from a startup IPO.
Instead, you want a road map that allows the allows for the appropriate amount of risk and keeps you pointed in the right long-term direction.
Decide how much risk you鈥檙e comfortable with
Investors who have decades to save should take more risk early on and gradually dial it down as retirement approaches. As a rule of thumb, you can subtract your age from 110 to find the percentage of your portfolio that should be invested in equities; the rest should be in bonds.
Of course, a rule of thumb doesn鈥檛 take other factors into consideration 鈥� namely, your risk tolerance. 鈥淎sk yourself, 鈥業f the market went down 50%, would I be able to stomach that, knowing I can expect it to go back up? Or will I make a mistake and sell?鈥欌�� says David Walters, a financial planner with Palisades Hudson Financial Group.
If you鈥檙e the type to jump ship, you may want to take a little less risk. If you live for that kind of thrill, you might take more. (Risk tolerance quizzes abound;聽.)
Weigh your investment options
401(k)s tend to have a small investment selection that鈥檚 curated by your plan provider and your employer. You鈥檙e not selecting individual stocks and bonds (whew!), but mutual funds 鈥� ideally聽聽鈥� that pool your money along with that of other investors to buy small pieces of many related securities.
Stock funds are divided into categories. Your 401(k) will probably offer at least one fund in each of the following categories: U.S. large cap 鈥� which refers to the value of the companies within 鈥� U.S. small cap, international, emerging markets and, in some plans, alternatives such as natural resources or real estate. Diversify by spreading the portion of your portfolio you鈥檝e allocated to equities among these funds.
鈥淵ou want to allocate more to the biggest asset classes, like U.S. large caps and international. U.S. small cap, natural resources and real estate are not as prevalent asset classes, so you鈥檒l take smaller bits of those,鈥� Walters says.
That might mean putting 50% of your equity allocation into a U.S. large cap fund, 30% into an international fund, 10% into a U.S. small cap fund and spreading the remainder among categories such as emerging markets and natural resources.
The bond selection in 401(k)s tends to be even more narrow, but generally you鈥檒l be offered a total bond market fund. If you have access to an international bond fund, you might put a bit of your savings in there to diversify globally.
You can search for risk ratings for specific funds on your plan provider鈥檚 website or on Morningstar.com.
Minimize expense ratios
Expense ratios are the fees carried by investments, and they range widely. They鈥檙e charged as a percentage of the amount invested.
You might find your 401(k) offers only one choice in some of the above categories, but when you have a selection, you should generally pick the lowest-cost option 鈥� often an index fund. Index funds invest by tracking an index, such as the S&P 500, so they鈥檙e less expensive than a mutual fund, which is actively managed by a professional. You鈥檒l pay for that person to pull the levers, and it often doesn鈥檛 translate into better returns.
Even small differences in fees can have a huge effect over time. Say you鈥檝e invested $100,000 at a 7% annual return: A fund with a 0.80% expense ratio could eat up $70,000 more of your returns over 30 years than a fund with a 0.40% expense ratio.
Expense ratios are disclosed on each fund鈥檚 page on your 401(k) plan provider website, as well as in the fund鈥檚 prospectus. 聽
Know when to outsource
If you鈥檝e fallen asleep by now, or you鈥檙e paralyzed with fear, you鈥檇 probably benefit from a little more help. You have a few options, all of which may cost slightly more than a DIY approach 鈥� but then again, it鈥檚 hard to put a price on peace of mind.
One is a target date fund, available in virtually all 401(k)s. These funds have a year in their names, designed to correspond to the year you plan to retire. If you鈥檙e 30, you might pick a 2050 fund. You put all of your 401(k) money in this fund, which diversifies for you and automatically takes less risk as you approach that year.
Another option,聽聽to a target-date fund, is a聽. These services manage your investments for you, setting your asset allocation and automatically rebalancing. There are currently two major robo-advisors that manage 401(k) plans:, which can manage any plan at any brokerage, and聽, which deals only with Fidelity plans.
Finally, it can pay off to work with a聽, even if it鈥檚 just a one-time meeting to get your goals and asset allocation in line.
Arielle O鈥橲hea is a staff writer at NerdWallet, a personal finance website. Email:aoshea@nerdwallet.com.
