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How to Choose Funds in Your 401k

Selecting funds for your 401k money isn’t always the easiest thing in the world. Often, the situation looks something like this:

  1. You’ve never heard of any of the investment options, and
  2. There’s no low-cost index fund option. (Note: If there is, it’s pretty likely that this is your best bet.)

Target retirement funds are usually a decent choice.

If your 401k offers target retirement funds as an option, they’re likely your next best bet (after a low-cost index fund, that is).

Target retirement funds (usually named something like “Retirement 2040”) hold a collection of other mutual funds. They adjust your asset allocation automatically as you approach the date you’ve selected as your goal for retirement. That is, they move your money from more volatile/higher earning investments toward less volatile/lower earning investments as you near retirement.

Two important things to check, however, are:

  1. The fund’s expense ratio, and
  2. The fund’s asset allocation.

The expense ratio is important because lower expense ratios tend to lead to better performance. And it’s important to check that the fund’s underlying allocation is appropriate for your own personal risk tolerance. (For example, sometimes the fund with a date that’s 15 or even 20 years earlier/later than the date you actually plan to retire will be the one that best fits your own needs.)

Other possible ways to choose

What if your retirement plan doesn’t offer target retirement funds? Or what if they’re offered, but they have hefty fees attached to them? At this point, there are a handful of factors you could look at:

  • Past performance
  • Expense ratio
  • Turnover ratio
  • Asset allocation in the fund as compared to your ideal asset allocation

Don’t rely on past performance.

Many people simply pick the fund that has the highest historical performance numbers. After all, that would seem to indicate that it’s the “best” fund, right? Unfortunately, basing your investments entirely upon past performance is almost a sure record for failure.

Why? Because, for most funds, periods of outperforming their peers are typically followed by periods of underperforming. It’s as simple as that. History has shown that it’s exceptionally rare for a fund manager to consistently outperform his peers. As such, betting on funds that have just had streaks of excellent performance is likely to yield poor results.

One way that past performance stats can be helpful, however, is in identifying true losers. While the top funds of last year are often below average this year (and vice versa), it’s actually fairly common for the very worst funds to hang out on the bottom of the pile year after year. Why? Because…

Expense ratios are extremely important.

Common sense tells us that–all else being equal–the less a fund manager charges the fund’s investors, the greater return the investors will earn.

For any given fund, the ratio of operating expenses to invested dollars (referred to as the fund’s “expense ratio”) stays quite consistent from year to year. Funds that had low expenses last year tend to have low expenses this year. As a result, a low expense ratio is one of the best indicators we have for predicting that a fund will show superior performance in the future.

Often, if you can find a fund that’s near the bottom of the pack in terms of 1-year, 3-year, 5-year, and 10-year performance stats, you’ll find that the fund also has a very high expense ratio. This isn’t really surprising. It’s exceedingly difficult for a fund manager to overcome the year-after-year handicap imposed by high expenses.

Look for a low turnover ratio.

A fund’s turnover ratio indicates what percentage of the assets held by the fund were sold during the course of the year. Higher turnover ratios result in higher expenses (in the form of transaction costs and unfavorable pressure on stock prices when buying or selling).

Like operating expenses, turnover-related expenses directly impact the fund’s return (in a negative direction). It’s important to note that these turnover-related expenses are not included in the expense ratio discussed above. Therefore, it’s worthwhile to take note of a fund’s historical turnover before selecting it as a suitable investment.

Be sure to check the fund’s asset allocation.

Finally, it’s essential to take a look at the asset allocation of each of the funds you’re considering. Make sure that–when considered together with the rest of your portfolio–the funds you choose in your 401(k) result in an asset allocation that’s fitting for your personal situation.

In summary:

  • If you have a low-cost index fund option, that’s probably your best bet for the stock portion of your portfolio.
  • If offered, target retirement date funds are likely to be an acceptable, low-maintenance option.
  • If neither of those is available, look for low-cost, low-turnover funds that will help you maintain an appropriate asset allocation for your entire portfolio.

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Comments

  1. You make a good point about Target Retirement Funds. I have linked to this post in my own post about – Target Retirement Funds.

    http://www.onemint.com/2009/01/27/what-is-a-target-retirement-fund/

  2. Great article! I found it very informative. I know all about individual investing, and the tax consequences of pension plans, but not really on how to make smart picks for a 401(k). I’m definitely forwarding this to my friends who aren’t as well versed in finance as me.

  3. Daddy Paul says:

    Index funds in a 401K are often the best route available. This article hits some points very well.

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