Choosing the right investments for your 401(k)

An employer-sponsored 401(k) can be one of the biggest wealth-building tools, but the pressure to select the "right" investments can be intimidating. Like a lot of important financial decisions, choosing where to invest your workplace 401(k) dollars depends on a lot of factors, including your timescale and risk appetite. But hopefully this post can help you feel a little more confident in your selections.

TLDR

Your 401(k) can be one of the easiest ways to create a retirement nest egg. But a little proactivity goes a long way in making sure you take full advantage of the opportunity it offers.

How much should you contribute?

Before picking investments, you'll want to think through the right dollar amount to contribute to your 401(k) altogether.

Here are some factors to consider:

1. Contribute up to your employer match, always. Free money is free money. If your company matches 50% up to 6%, that's an instant 50% return on your money. This step is a no-brainer.
2. Make sure your IRA (and your spouse's IRA) are funded. These offer more investment options and more control than a company plan, so once you've captured the match, this is a good next step.
3. Double check that your emergency fund is where it needs to be. It doesn't make sense to throw every extra dollar into your 401(k), and then have to use a credit card for an expected expense. Beyond avoiding debt, a properly funded emergency fund shields your retirement savings by reducing the possibility that you might need to borrow from it down the road.
4. Think through other financial goals that are years away, but not as far away as retirement. Things like a down payment on a house, a vacation property, purchasing a car, etc. Depending on the time frame for each goal, putting money in a brokerage account might make sense. Yes, that means you're subject to taxes, but it also means you'll be able to use that money before age 59½ (some exceptions apply).

Important: make sure your money Is actually invested

Here's a horror story: imagine signing up for your 401(k), pick a contribution percentage, and let the money accumulate over the next few years of employment. The market is booming, and life is good. One day you log in, however, only to discover that your entire balance has been sitting in a cash position, missing out on all those gains while inflation chips away at it.

Unfortunately this story isn't fiction—it happens more often than you'd expect.

The fix is simple: when it comes to your 401(k), don't just "set it and forget it." Once you've elected your contribution amount, wait for the first payroll to process, then make sure it arrives in your account. Check and double check that the percentages you've allocated to different investment buckets align with the real dollar amounts you see in your account.

Set a reminder to check this a few times a year. It takes just a couple of minutes and can save you from missing out on tens of thousands of dollars in missed growth.

In-N-Out vs. Cheesecake Factory

For the uninitiated, the Cheesecake Factory's menu is legendary in size. It offers page after page of appetizers, entrees, and of course desserts. When it comes to 401(k) plans, however, your menu of investment options typically looks a lot more like the board at In-N-Out. It might be simple, but that's not necessarily a bad thing. Your job is to build the best meal (portfolio) possible from this limited menu.

Most plans will offer some combination of:

• A target date fund
  A fund that automatically increases the proportion of bonds vs. stocks as the investor gets closer to retirement age. The principal value of a target fund is not guaranteed at any time, including at the target date. The target date is the approximate date when investors plan to start withdrawing their money.
• A handful of index funds (usually S&P 500, total market, or similar)
  The S&P 500 is a stock market index tracking the stock performance of 500 of the largest companies listed on stock exchanges in the United States. Indexes are unmanaged and cannot be invested in directly.
• Some "actively managed" funds
• International funds
• Bond funds
• Maybe a small-cap or sector-specific option

The downside of target date funds

Target date funds get pitched as the "set it and forget it" option, and for a lot of people, they're fine. But they come with two catches:

1. Target date funds include a combination of bonds and equities, and the percentage of each gets "adjusted" as you get closer to retirement. If you're in your 30s or 40s with decades until retirement, you might prefer reducing the amount of money in bonds.
2. Target date funds also typically reflect higher expense ratios, which means you are paying additional fees for someone to "manage" them. These expense ratios can eat away at our returns and hamper the benefits of compounding.

Keep an eye on expense ratios

It's not just target date funds that can carry high expense ratios. Some mutual funds will charge 0.75% to 1.5% in annual expenses, while a nearly identical index fund might charge 0.03% to 0.10%.

That difference sounds small, but compounded over 20-30 years, it adds up to tens of thousands of dollars in lost growth. Pull up your plan's fund lineup and check the expense ratio on every fund you're considering. If there are two similar options, like an S&P 500 index fund and an actively managed large-cap fund, the index fund is pretty much always the better bet.

Hedging against a "tech bubble"

The S&P 500 and other indexes are currently more concentrated in tech—and AI specifically—than ever before. In the past, many investors felt fine about going all in on the S&P 500, but a growing number of people are worried about the possibility of a bubble. Whether or not a correction comes, the principle is a good one to consider: diversification is a good thing! (There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.)

Here are a few ways to diversify away from a tech-heavy S&P:

• International funds give you exposure to companies outside the U.S., which tend to move somewhat independently of American tech stocks. (International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.)
• Emerging markets funds add exposure to faster-growing economies with different economic cycles.
• Healthcare funds are less tied to tech sentiment and tend to hold up better during tech-specific downturns.
• Energy also moves on a different set of drivers (oil prices, geopolitical events) rather than tech earnings.

You don't need to overhaul your entire portfolio, but carving out a percentage of your 401(k) for a few of these categories, assuming your provider offers them, can smooth out your ride if tech stocks hit a rough patch.

A few more recommendations

• Increase your contribution percentage every time you get a raise or pay off debt. An increase of 1-2% a year adds up significantly by retirement.
• Don't chase performance. If a fund had a great year last year, that doesn't mean it'll repeat. Stick to your strategy.
• Review your plan's fund lineup at least once a year. Companies sometimes swap out funds or add new lower-cost options, and you want to know if something better becomes available.

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.

This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.

Asset allocation does not ensure a profit or protect against a loss. The NASDAQ Composite Index measures all NASDAQ domestic and non-U.S. based common stocks listed on The NASDAQ Stock Market. The market value, the last sale price multiplied by total shares outstanding, is calculated throughout the trading day, and is related to the total value of the Index. Indexes are unmanaged and cannot be invested in directly.