How Should I Invest My 401k? 7 Steps to Making a Decision

Disclosure: This article is written for entertainment purposes only and should not be construed as financial or any other type of professional advice.

If you invest in your 401(k) and stay invested, your account balance can grow to $1 million or more. According to CNBC, about 72,000 people have reached the status of 401(k) millionaire at the end of 2014.

But before you can accumulate a healthy retirement account balance, you need to decide how to invest your 401(k) dollars. Based on my readings, many people struggle in selecting investments. Here are action steps that may bring clarity and offer guidance in making a decision:

Find out what the 401(k) plan’s investment choices are

Each 401(k) plan has its own investment choices. So, your retirement plan’s offerings should be the same as your coworkers but may not be similar to that of your friends and neighbors who work for different companies.

According to FINRA, most plans have at least three investment choices but may contain many more. Some even allow brokerage accounts, giving you a broad range of choices that include individual stocks and bonds as well as mutual funds and ETFs.

Determine where your risk tolerance falls on a conservative to aggressive continuum

Many 401(k) providers indicate desirable choices for employee investors based on individual risk tolerance. Investment choices may be labeled as conservative, moderate, or aggressive. Plan providers suggest that employees learn about their risk tolerances and then choose products accordingly.

If you are a new investor, you may not know your risk tolerance, which references the amount of money you are willing to lose as a trade-off to the possibility of experiencing greater-than-average gains.

Consider taking an assessment to get an understanding of personal risk tolerance. Find an online quiz that can give you insights into your preferences for conservative, moderate, or aggressive investing.

There are many factors in making an investment selection. As for me, my risk tolerance is a factor in making a decision but not the only one.

Decide whether you want the 401k portfolio to be diversified itself or part of a diversified portfolio

Before making your selections, consider whether you want to manage your 401(k) plan as a standalone portfolio or as a component of a diversified portfolio.

If you’d like to measure the performance of your 401(k) as compared to your advisor’s approach or your own strategy, then you may want to create a diversified portfolio.

Alternatively, you might consider using your 401(k) assets to diversify your entire portfolio. In this case, you might choose a mutual fund that is focused on stocks of emerging economies or real estate investment trust (REIT) funds if those are otherwise absent from the rest of your investment portfolio.

In terms of simplicity, treating your 401(k) as its own standalone portfolio may be desirable if you have few assets outside of this retirement plan. However, if you have significant holdings in regular brokerage accounts and IRAs and those holdings are concentrated in a certain asset class or market segment (large growth stocks, for example), then you may want to use the 401(k) to provide balance to your portfolio.

Determine your desired asset allocation

There are many tools available to develop an asset allocation synced with your risk tolerance and your time horizon (note that these may be considered simultaneously). For example, the American Association of Individual Investors (AAII) provides sample asset allocation models for conservative, moderate, and aggressive investors that indicate age ranges associated with risk levels.

In general, an asset allocation may indicate simply the mix of stocks, bonds, and cash. But an allocation may also offer a more detailed breakdown among large-cap, mid-cap, and small-cap U.S. stocks; international stocks; emerging markets stocks; intermediate and short-term bonds.

Consider using your desired allocation to guide selections among the 401(k) plan’s investment choices.

Review the cost of 401(k) plan investment products

Evaluate the costs associated with individual investment choices. Review and compare total annual operating expenses and shareholder-type fees for each selection.

These investment fees may include:

  • sales charges aka loads or commissions, which are often called front-end loads, back-end loads, deferred sales charges or redemption fees on mutual funds
  • 12b-1 fees on mutual funds
  • management and administrative fees for mutual funds, collective investment funds, and stable value funds
  • insurance-related, surrender, and transfer charges associated with variable annuities

Target-date funds, particularly those that are funds-of-funds, may carry admin and management fees for the fund purchased in addition to fees embedded in the underlying funds.

There may be additional fees attached to your 401(k) that you’ll pay regardless of your investment choices. For this exercise, consider focusing on the ones linked to specific selections only.

Consider the investment style and other relevant factors associated with your investment choices

Your investment choices are likely to represent various investment styles and market segments as well as varying investment returns over time and benchmark (index) comparisons. This information should be provided to you through 401(k) plan documents and/or enrollment presentations.

To get a deeper insight into your choices, do research on individual selections using Yahoo! Finance, Google Finance, or your online brokerage firm’s research tools.

You may enjoy using Morningstar’s Portfolio Manager, a free portfolio management tool. Enter the ticker symbols of your current (or anticipated) holdings and associated dollars invested to analyze your portfolio. The Instant X-Ray gives you a breakdown in terms of asset allocation, investment styles, and more. Compare the results to your ideal and make adjustments in selections as needed.

Ask for help from a qualified professional

Depending on the number of investment choices your plan offers and your comfort in making an independent decision, you may want to consult with a financial professional.

Your employer may provide educational services that can help you make a decision, or offer access to an adviser knowledgeable about the plan and equipped to assist employees. Alternatively, consult with your own fee-based financial adviser if he or she is qualified to make investment recommendations.

If you prefer an online resource, consider visiting the section of FutureAdvisor’s website dedicated to 401(k) plans. There, you can find investment choices with recommended allocations for specific employer plans; enter your age and risk tolerance to get customized results. (See my review of FutureAdvisor).

Even if you decide to consult with an adviser, consider reviewing investment fees, objectives, and past returns associated with various investment choices, and determine your risk tolerance and asset allocation. By completing this task, you’ll be prepared to answer questions your adviser will have (or should have) and be in a better position to collaborate on a solution or judge recommendations.

A simple answer to the “how should I invest my 401(k)?” is the default option, which may be a target date or lifecycle fund associated with your retirement date. But you may want to be more thoughtful about your approach or consider other choices even if you ultimately decide on a target-date fund.

You may be interested to know that the 401(k) millionaires hold 72% of their investment balances in equities (individual stocks or stock funds) according to Fidelity’s Jeanne Thompson. And, at the end of 2014, just 12% of those equities represented company stock. These investors tend to focus on growth, even though this approach carries a greater risk of loss.

Your investment selections may look much different than those who choose the default or invest more heavily in equities. Consider choosing among investment options based on factors such as your risk tolerance and time horizon, investment fees, and desired asset allocation.

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