Which funds should I choose in my 401(k)?

Figuring out that you should be contributing to your 401(k)/457(b)/IRA is a great first step. Now which funds do you pick?

Investor Policy Statement

The first thing I’d recommend would be to write up a list of investing goals and strategies, sometimes referred to as an Investor Policy Statement. The best example I’ve seen online, with specifics, can be found in a Physician on Fire blog post. If you have no idea how to determine your goals or desired asset allocation, etc., it probably means that you’re probably not ready to competently select your investments. That’s ok! You just need to keep reading and absorbing information and you’ll be on top of things in no time.

Avoid the temptation to simply chase past performance

It may be easy to sort funds by past performance. Given that there will be a number of options, one or more of the high expense actively managed mutual funds is bound to have beaten a lower cost index fund in the last few years. But over time, low-cost index funds will outperform 90+% of those funds, so chasing past performance is a no go. In other words, there is a great probability that the actively managed fund that outperformed in the past will not continue to do so in the future. And on top of that, it will still carry higher fees. Research has shown that the only thing that you can really control is fees, so keep them low. Here is some additional reading.

Figure out your desired asset allocation

Do some reading on the Bogleheads wiki page or read this post on Asset Allocation. The short version is that it makes sense to be aggressive (e.g., 80% stocks / 20% bonds, or even 100% stocks) early in your career so that you can build wealth, and then more conservative (e.g., 55% stocks / 45% bonds) near retirement so that you can hold on to the wealth that you’ve accumulated. Investing in equities (stocks) is more aggressive with wilder swings up and down, while bonds are more conservative and stable, but with a lower overall expected return. It’s easy to be skeptical of bonds during a bull market, but remember that they’ll smooth the ride during a bear market. In no case should you ever sell during a down market, so choose an allocation that you can live with.

Target Date Funds

One easy solution if you want to set it and forget it (which is a good idea, since too much tinkering tends to backfire) is to choose target date funds. These funds gradually become more conservative over time. They are a great option if your provider offers a low cost fund such as a Vanguard target date fund. Simply choose your target date of retirement and you’re done. If you wanted to be a bit more aggressive, then choose a date 5 years beyond your expected retirement date. To be more conservative, do the opposite. It’s not worth paying a huge premium of more than a few basis points for these funds though.

Expense ratios

When I say low-cost fund, I’m referring to the fact that each fund carries an annual expense ratio. 1 basis point = 1/100 of one percent. So an investment of $10,000 into a fund with an expense ratio of 0.75% (or 75 basis points) will amount to $75 per year. Not terrible. But when your account grows to $1,000,000, that cost is $7,500 a year – nothing to sneeze at! That’s why it’s important to choose funds with as low an expense ratio as possible, although in reality, three or four basis points isn’t going to make or break anyone’s retirement.

Putting it together

If you’ve elected not to go with a single target date fund, then you’ll need to find low-expense index funds to create a three fund portfolio, i.e., funds that approximate (1) A total market domestic fund, (2) A total market international fund, and (3) a total bond fund, all with the lowest expenses possible. 

Ideally, your plan may offer ‘institutional’ shares, which have the lowest expense ratio. I prefer Vanguard. For domestic funds, your top picks would be Vanguard Institutional shares (VINIX) or Admiral shares (VTSAX) [0.04%]. An alternative would be Fidelity’s total domestic market fund premium class (FSTVX) [0.04%].

You can do the same for international funds – Vanguard’s total international fund is VTIAX [0.11%]. Fidelity’s is FTIPX [0.06%]. In a 401(k), a safe bet for bonds is a total bond fund such as Vanguard’s VBMFX [0.15%].

Once you have selected your funds, you should be able to allocate certain percentages to each fund. Remember to change both your future elections, and rebalance your accounts current holdings if you elect to do so.

What ifs

What if your provider doesn’t offer these funds? Then you’ll look at what is offered and try to find either one low-cost target date fund, or create a 3 fund portfolio with similar funds to those above. Nothing should carry expenses greater than 0.25%. Ideally they should be 0.15% or less.

If the best option is more expensive, then you may be out of luck and stuck with relatively poor choices. But remember that you’re still getting the advantage of a tax-deferred account, so make the best picks that you can. Just literally read the description and compare expense ratios side-by-side. The only thing I would consider is that if there were, say, a great low-cost option for a domestic fund but only a high cost international fund, then I might skip international in my 401(k) and place it in another account where I could find a low cost option.

What about alternative investments such as REITs, or tilting towards small value funds? As long as you have done your research, and your 401(k) offers a low-cost pick for the type of fund, then it’s fine to explore alternative investments or portfolio tilting. Here is a sample slice and dice portfolio from the Coffeehouse Investor:

But remember that you don’t really need a bunch of funds. An index fund is by its nature diversified. To be fair, it is potentially easier to slice and dice in an automated 401(k) than a taxable brokerage account. But any tilting or factor investing is playing a bit of a guessing game, so when in doubt, keep it simple.

Specific Recommendations Based on Company

There is a resource that some people talk about that makes specific recommendations based on a company’s 401(k) plans. It’s hard to keep it up to date because offerings change, but it can be a good starting place. They say the basis of the picks is a “proprietary database” but they seem to vary company to company, even when similar funds are offered! So I’m not sold on using these recommendations. But if you work for a big company, feel free to check it out and let it serve as a starting place: Paul Merriman.

Final Note

Remember that because your investments grow tax-deferred, there is no penalty to exchange (buy/sell) funds within your account. This is in contrast to a taxable account, where it’s easier to get locked into certain funds for fear of the tax consequences of selling investments that have risen in value. On that note, if your account gives you the option to automatically “rebalance” your investments, go for it. This will help your assets stay on track with your preferred allocation. When stocks are doing well, you will essentially be selling high, and when they’re doing poorly, you’ll be buying when stocks are cheap. Research has shown that a rebalanced account gives you a slight edge over time. As to frequency, rebalancing quarterly or semi-annually should be fine, as doing so more often has not been shown to carry much additional benefit.