How to Invest Your 401(k) Contributions

how to invest 401k contributions

Recently, Corey posted on How to Start Saving for Retirement. I wanted to take this a step further and help out the readers with how you should invest your retirement savings.

When I first started working, I had a good idea of how I wanted to invest the money I was saving in my 401(k). I think this was because finance is what I went to school for. Many of my friends would ask me to help them out with picking their investments in their 401(k) accounts. When I would see their statement of what they were currently invested in, it saddened me.

I saw everything from leaving everything in cash, to 100% bonds, to one friend dividing up his investments into nine different funds. Nine! When I approached him about this he said that since there were so many options, he thought he was supposed to choose a bunch of them.

The main theme I heard from most is that they were overwhelmed. They had no idea what to invest in. Most simply looked at how the funds performed in the past and picked the ones with the highest returns. Even the benefits person at their place of employment that they were told to call with questions didn’t help out. Luckily, help is here.

Your first step is to get a complete list of all of your investment options in your 401(k) along with the management fees the funds charge. You should have an enrollment booklet from when you were hired. If you don’t have it, contact human resources.

Your Plan

Once you have this information, you are to pick three funds to start: A domestic stock fund, an international stock fund, and a bond fund. You will invest:

  • 50% in the domestic stock fund
  • 30% in the international stock fund
  • 20% in the bond fund.

This will give you an 80% stock, 20% bond portfolio.

For example, if you save $100 per month, $50 goes into the domestic stock fund, $30 goes into the international stock fund, and $20 goes into the bond fund. If you are just starting out, you should be able to handle this amount of risk. If this is too much risk for you, then you can lower your stock holdings to 60% stocks (40% domestically and 20% internationally) and 40% bonds. I don’t recommend going lower than this since you have close to forty years until you will need this money. You need the money to grow and can afford the risk at your age. If you are still nervous about the risk, read the benefits of compound interest. This hopefully will sway you. If note, you can follow my plan when you are scared of the stock market.

I cannot tell you the exact funds to pick, as everyone has a different 401(k) plan and different investment choices. I can tell you this though: Look at the management fees. If any domestic stock fund has a management fee over 1%, cross it off the list. It is too expense. Ideally, you will want something that compares itself to the S&P 500 Index. If you don’t have anything that does this, then pick a large cap fund.

When it comes to international stock funds, I hope that you can also cross out anything that charges more than 1% in management fees as well. However, judging by what I see, most of you won’t have this option. My advice is to look for an international fund that invests in the entire international market or an emerging markets fund. If you have multiple choices, pick the one with the lower management fees. If all of your international choices charge you more than 1.25%, then do not invest in an international fund in your 401(k). You can do so in a Roth IRA or Traditional IRA and pick something with a much lower management fee.

For your bond fund, pick a fund that invests in the entire bond market. If you don’t have that choice, look for a short-term bond fund. Again, look for a management fee under 1%.

I do not recommend looking at the target date funds. They aren’t all they are cracked up to be. They are riddled with fees and don’t do as good of a job as they claim.

I hope this clears the air for many new employees investing in their 401(k) plans for the first time. If you have any questions, please comment below or email me and I will be more than happy to help you out. I cannot pick the exact fund for you to invest in, but I can guide you.

25 Responses to How to Invest Your 401(k) Contributions

  1. An 80% / 20% split is not the perfect mix for everyone. People should also consider other factors such as time until their retirement, whether or not they have a pension, how other investments (Roth IRAs) incorporate into their portfolio. Not everyone will be a flat 80/20.

    • Interesting, Hank. Just curious; do you think we should be taking more risks based on our age? (I’m 30, Jeff is 34.) Just using us as an example as I’ve heard that we should be taking more risks at our age. Although I feel very young still, I look at my age as being almost halfway to retirement! It doesn’t seem that far off when I think about it in that sense. Anyone else can answer as well!

    • I agree that 80%/20% isn’t for everyone. That’s why I explained how to invest in a 60%/40% portfolio as well. You are correct that you need to take into account how long you have until retirement when deciding on your allocation.

    • Vanguard is great for low cost funds. Unfortunately not many employees have access to these funds in their 401(k) plans, so they need to do a little work to determine which funds that are in the plan have to lowest fees.

  2. Great Article! I’ve heard some friends in the invesment business say the best way to invest one’s money is to put 90% in safe investments like bonds, index funds, etc. and put 10% in very risky investments. Has anyone experimented with something like that?

    • Interesting to hear that. I haven’t heard anything like this, but will look into it. Realize though that index funds are completely ‘safe’, depending on your definition of the word. You can invest in an international index fund which carries some risk with it and one I wouldn’t consider safe. But safe to me means bonds or bank CD’s.

  3. Thanks for the article. So often blog posts talk about saving for retirement but usually there’s no guidence on which funds to put the money. My company does not offer a 401k so all my retirement is in a Roth IRA. Right now it’s in a target date fund since I don’t have enough to allocate to multiple funds.

    • This is a great point. When your plan has few investment choices, you can look for a balanced fund that has a stock/bond allocation built into it. You can then invest more ‘strategically’ in your IRA.

  4. I agree with Hank – the 80/20 ratio may be a suitable for someone in their early twenties, but a little too risky for older participants. Generally, I subtract a participants age from 100. Invest that amount in riskier securities and the remainder in stable value funds. As you said though, the amount can always be altered based on the investor’s risk tolerance and time to retirement.

    Also, in my 401k, I hold a great domestic/international real estate fund. It’s performed very well for me and I think it will continue to do so.

    • Great to hear about the real estate fund. I’m glad you saw that I did show a less risky plan for those that are more risk adverse. After reading Hank’s comment I was nervous that I didn’t go into enough detail about it.

  5. It all depends on your risk tolerance. One of the first things an investment advisor or CFP will do is have you complete a risk tolerance questionnaire. You can even do this yourself as there are questionnaires available online. This will serve as a guide for how much exposure to equities you might want to start with. As has been said before, building a portfolio depends upon many things, risk tolerance, short-term and long-term goals, expected inflation and return rates, as well as an accurate estimate of income needs in retirement. A risk tolerance questionnaire might show that you are risk adverse and a less risky 60/40 equity/bond mix might be recommended however, in reality this conservative mix might not generate the returns to fund your retirement needs.

  6. Well done you. Anyone trying to help plan participants decide what to do with their 401k investments (other than default Target Date Funds) is doing a great service.

    For the 20-30 yr old crowd, the split is not at all offensive. Yet, after they accumulate over $50k and the money is beginning to “feel” real, buy and hold (which is what any fixed allocation is really about) needs to be addressed.

    To be sure, buy and hold has not worked for the last 12 years. At some point, an investor will want his or her “pie on the table” vs “pie in the sky.”

    So, investing takes on a different focus which begins with what is called a top down approach. The first question is: are we in a market that is worthy of my investment capital – today?

    Face it, a 58-60 year old worker does not have 20 years to make up for catastrophic losses like we saw in 2008.

    From there, the question is: which asset classes are demonstration relative strength over the other choices available – today?

    In this market, I would not be recommending ANY international asset class or commodity asset class. In fact, the highest ranking asset class is Domestic (US) Equities; however, it is not presently outperforming a cash proxy. But, things always change in the market.

    The best advice for any young 401k plan participant is to participate in the plan and capture as much of the company match as possible.

    Best regards,

    • I would disagree with some of your points. Where I work, we stress buy and hold strategy. For those of our clients that have stayed invested before, during and since the market collapse, all are at or above where they were when the market dropped. We even have a couple where the wife stayed invested and the husband got out at the end of 2008 in their individual accounts. He complained about his horrible returns while she has been doing just fine.

      Also, you need a diversified portfolio that includes international holdings. Without this mix, you aren’t going to earn a return that you could have otherwise earned.

      • @ Don: Interesting observations. Let me throw down a challenge.

        Let’s assume the market topped out Sept. 2007; you suggest clients are at least as well off as they were back then. (FYI the SPX has still not come back to that high point – see BigCharts dot com.)

        Answer us this: how much of the account balance which is now “at or above where they were when the market dropped” is due to new money?

        In other words how much money has been ADDED to the account from employee and employer contributions over the last 58 months?

        Just asking.

        • Great question. When not taking into account any new money added into they account (other than reinvested dividends from the investments they originally held), clients are at or above where they were.

          While you reference the SPX, our clients are in a diversified portfolio of US large and small cap funds (both growth and value), international funds (large and small), real estate and commodities. We also regularly rebalance their portfolios as well.

          So while the SPX alone isn’t back to it’s previous high, diversifying one’s portfolio and rebalancing has allowed for them to get back to where they were before the meltdown.

          • Well then, if, as you say,

            “We also regularly rebalance their portfolios as well.”

            then, in fact, you do not believe in buy and hold.

            We are in agreement.

  7. I have never been a big fan when it comes to investing directly in stocks in a 401k. Its better to use exchange traded funds closed end funds or opened ended funds when it comes to 401 k’s. For the simple reason that you need to invest safely when it comes to money that you will need when you finally stop working.

  8. @George: For whatever reason the system isn’t letting me reply directly to your last comment above. The rebalancing that is done on the accounts does not completely buy and sell out of funds, it simply get the portfolio back in line with the IPS when it is out of line. So when the US large value fund is over-weighted, we would sell a little to get it back in line and buy a fund in the portfolio that wasn’t performing as well.

    Just because you rebalance doesn’t mean you don’t buy and hold. They aren’t the same thing. Rebalancing is simply a tool used to help people not take on too much or too little risk when the market values of the funds change over time. Rebalancing isn’t done every day either. The portfolio is reviewed quarterly and rebalanced only if the variance is large enough.

  9. Just teasing. I know they are not the same. But, since you brought it up, let’s expand on that thought. This I believe…

    “Rebalancing” is one of the most brilliant marketing words Wall Street ever developed. Who doesn’t want to be balanced… in life, relationships, work, play, and especially in our personal finances?!

    Yet, the truth of how portfolios are rebalanced is an interesting topic. What is happening is the money manager who is MAKING the most money for the client is being fired; and, the money manager who is under-performing is being rewarded with more money to manage.

    If I applied this concept to a business situation it would be like firing some of my most profitable clients and taking resources to service clients that are buying the lowest profit margin products or are slow pay or are otherwise not contributing to my overall profitability. Why? Well to hold to the the THEORY of “Rebalancing” they are making me too much money.

    If you suggested that strategy to a business person, in the name of “Rebalancing” their customer base, they would rightfully throw you out the door!

    Rebalancing simply for the sake of maintaining a predetermined mix of asset classes is foolish. As Emerson said, “A foolish consistency is the hobgoblin of little minds.”

    I don’t have time right now; but, I will comment a bit more on the “New Money” piece from the prior comment.

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