How to invest your 401(k)

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The 401(k) is one of the most popular retirement plans for good reason. It offers a way to save for the future and receive tax benefits — both lowering current taxable income and deferring taxes on investment gains — for doing so. But the shortcomings of the 401(k) include a limited selection of investment funds and the need to select those funds yourself. If you are lacking in expertise at investing, it may prove to be challenging to maximize your portfolio.

Here’s how to pick investments in your 401(k), including a number of key things to pay special attention to.

Picking your 401(k) investments

A 401(k) plan typically offers at least 10 or 12 investment funds, though some plans may offer a few dozen choices, including target-date funds. How do you choose among these options?

For many, the limited selection of funds in a 401(k) may be more of a benefit than a drawback, helping to simplify the process. For experienced investors, a limited fund choice is, well, limiting. These investors might prefer the unlimited selection available in an IRA. But most 401(k) participants want a good solution (high returns) rather than a perfect solution (the best returns).

There are two broad factors that 401(k) participants should look at:

  • Long-term returns: These are the returns on the fund over five- and 10-year periods, as well as since inception.
  • Expense ratio: Basically, this is the cost to hold the fund for a year as a percent of the money invested in the fund.

Participants should search for the best returns at the lowest costs, all else equal. You’ll have to make a trade-off between the performance and the fund’s expenses sometimes, too. But it may be worth paying a higher fee for the prospect of much better long-term returns.

You’ll want to be careful about buying any fund that’s had a good recent performance, such as one- or two-year returns, but has delivered a mediocre performance over longer periods. Many investors make the mistake of chasing a hot fund, only to see its performance drop in the future.

“A fund that has performed well consistently and is in the top third works for me,” says Morris Armstrong, a registered investment advisor at his own company in Cheshire, Connecticut. “I look at the expenses of the fund and usually choose funds that are lower cost than higher. The low cost may be one of the reasons why they are in the top third.”

If you opt for a target-date fund, you can mostly skip choosing your investments. In this kind of fund, you choose when you need the money – your retirement date, for example – and the fund does the rest. It’s more of a “do it for me” solution, but you’ll likely pay more for the privilege. Skip below for more details on target-date funds and what advantages they offer.

If you’re looking to manage the portfolio yourself, you’ll want to have a look at the other funds available in your 401(k). They can vary substantially in terms of risk and return.

How to build a 401(k) portfolio

If you decide to pick investments yourself, you’ll want to keep some important principles in mind to make smarter investments:

  • Consider your financial goals: Your portfolio needs to reflect your financial goals. For example, if you want higher returns, your portfolio likely needs to have more invested in stock funds.
  • Diversify: A diversified portfolio helps minimize risk and may actually help increase your long-term returns.
  • Assess your risk tolerance: Avoid taking on too much risk. You want to have a portfolio that grows but also allows you to sleep at night.
  • Evaluate your time horizon: More time until you need the money means you can take more risks and generate higher returns.

So beyond just selecting the best funds at the lowest costs, your fund selection and how much you invest in each fund depends on your personal financial situation and goals.

Diversification is an important factor, and you’ll want to balance having too much in one type of asset. For example, many experts recommend having an allocation to large stocks such as those in a S&P 500 index fund as well as an allocation to medium- and small-cap stocks. While stocks often rise (and fall) faster than bonds, bond funds play a more stabilizing influence on a portfolio and generate reliable income, too – valuable in periods of turmoil.

But if you look only at the costs and returns of stock and bond funds, you may end up with a portfolio of only stock funds. You’ll need to balance the risk of each type.

As for risk tolerance and time horizon, if you’re in your 20s and 30s, for example, you may want to consider a higher allocation to stocks. But with less than five years to retirement, it makes sense to become less reliant on stocks to lower your risks and ensure you’ll have the money in your account when you need it.

That can be a challenge, because you “must select funds for the different asset classes and decide in what percentage you want them to be,” Armstrong says. “A 30-year-old should likely have a higher exposure to stocks than a 60-year-old, but often chooses to be too conservative.”

“If you are not that familiar with investing, some plans offer a solution that produces a suggested allocation based upon answering a series of risk tolerance questions,” says Jeffrey Corliss, CFP, managing director with RDM Financial Group at Hightower in Westport, Connecticut.

“Once you have set up your investment allocation, for the most part you should leave it alone and revisit it on an annual basis,” Corliss says. “If you are creating your own portfolio, make sure you rebalance regularly. That way your investment allocation will not get too far out of alignment from your desired portfolio.”

One other point to note, though it may already be reflected in a fund’s returns and costs: Passively managed funds such as index funds based on the S&P 500 or other broad stock market indexes tend to outperform the vast majority of actively managed funds. Not only that, passive funds are usually much cheaper.

“Active managers have a hard time beating index funds,” Armstrong says.

If your 401(k) plan is truly abysmal – high costs and low returns – then you do have some alternatives such as an IRA. However, an IRA lacks one of the key advantages of a 401(k) plan, the potential for an employer match.

Even if your 401(k) is poorly set up, you should take into account whether your employer offers any matching funds when you contribute to the account. If so, it is a huge advantage to accumulating wealth, compared to doing it yourself in an IRA. The match is free money, and you should generally try to get as much of the match as possible. Then you can turn to your IRA.

What kind of investments are in a 401(k)?

A 401(k) plan will typically offer a range of investments, but any single plan may not offer all possible types of investments. The most common investment options include:

  • Stock mutual funds. These funds invest in stocks and may have specific themes, such as value stocks or dividend stocks. One popular option here is an S&P 500 index fund, which includes the largest American companies and forms the backbone of many 401(k) portfolios.
  • Bond mutual funds. These funds invest exclusively in bonds and may feature specific kinds of bonds, such as short- or intermediate-term, as well as bonds from certain issuers such as the U.S. government or corporations.
  • Target-date mutual funds. These funds will invest in stocks and bonds, and they’ll shift their allocations to each based on a specific target date or when you want to retire.
  • Stable value funds. These funds invest in low-yield but very safe assets, such as medium-term government bonds, and the returns and principal are insured against loss. These funds are more appropriate for investors near retirement than for younger investors.

Some 401(k) plans may also allow you to buy individual stocks, bonds, ETFs or other mutual funds. These funds give you the option of managing the portfolio yourself, an option that may be valuable to advanced investors who have a good understanding of the market.

Choosing a target-date fund

If you want to manage your own investments, that’s great, but many 401(k) participants would prefer to have someone else do it. While some 401(k) plans may provide some guidance, and even allow you to speak with a financial advisor, many don’t feature this option. In this case, a target-date fund can be an alternative that fills the gap with a professionally created portfolio.

“Target-date funds are investment choices in which the fund family creates an allocation based upon your target retirement date and possibly your risk tolerance,” Corliss says.

As you near the target date, the fund automatically becomes more conservative, shifting away from stocks and toward bonds. “For example, a 2045 target date fund will be more aggressive and usually have a higher percentage of equities than a 2025 target date fund,” Corliss says.

While target-date funds may differ somewhat from company to company, they’re generally well-diversified and rebalance automatically.

“For many people, selecting a target date fund is the ‘safest’ choice and allows for a set-and-forget mentality,” Armstrong says.

Target-date funds aren’t perfect solutions either, though they do help with creating a diversified portfolio. Participants in a 401(k) plan should still pay special attention to these funds’ expense ratios, which can be much higher than a passively managed index fund.

Another issue is the fund’s allocation to stocks and bonds.

“You should not necessarily choose the date closest to when you want to retire,” Corliss says. “Sometimes the allocation used in that date may be too heavily invested in equities for your particular risk tolerance.”

At the same time, some experts even recommend selecting a target date that’s 10 or 15 years beyond your actual retirement date. The rationale here is that as people are living longer they need the higher allocation in stocks, which grow faster, in order to avoid outliving their retirement funds.

Some 401(k) plans may also offer a type of investment called an asset allocation fund, which places investments in asset classes with various allocations to stocks and bonds. The funds might be called aggressive, moderate or conservative. More aggressive funds will have higher allocations to stocks, while more conservative funds will tend to have more bonds.

“Before you invest in these, you need to do your homework and investigate what the allocation is to see if it is suitable to your risk tolerance,” Corliss says.

Can you lose money in a 401(k)?

It’s possible to lose money in a 401(k), depending on what you’re invested in. The U.S. government does not protect the value of investments in market-based securities such as stocks and bonds. Investments in stock funds, for example, can fluctuate significantly depending on the overall market. But that’s the trade-off for the potentially much higher returns available in stocks.

That said, if you invest in a stable value fund, the fund does not really fluctuate much, and your returns or yield are guaranteed by private insurance against loss. The tradeoff is that the returns to stable value funds are much lower, on average, that returns to stock and bond funds over long periods of time.

So it’s key to understand what you’re invested in, and what the potential risks and rewards are.

Bottom line

The world of investing is unfamiliar to many 401(k) participants, so it’s important to learn some of the basics even if you don’t intend on picking funds yourself. Learning about your options can save you a lot of money and even help you make more money.

“Whether you decide to create your own allocation or use one of the pre-designed portfolios, make sure you know what you are investing in,” Corliss says.

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Written by
James Royal
Senior investing and wealth management reporter
Bankrate senior reporter James F. Royal, Ph.D., covers investing and wealth management. His work has been cited by CNBC, the Washington Post, The New York Times and more.
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Professor of finance, Creighton University