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How to Pick Investments for Your 401k

Today we discuss how to pick investments for your 401k.  Do the performance statistics matter?  What about expenses? What are the most important things you can do to pick the right funds?

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How to Pick investments for your 401k

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How to Pick Investments for Your 401k

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How to pick investments for your 401k

Today we have a question from Randy. He writes, “I’m trying to choose investments for my 401k. How important are the three-year and five-year returns when picking the funds? What should I be focusing on to choose the right investments?”

401k plans are wonderful savings vehicles. But oftentimes, you get very little guidance about how to select the investments. Some plans have hundreds of options. Other plans may only have a dozen. It is hard to know which ones to pick to help you achieve your goals.

Information Overload

Plan sponsors provide a lot of data about the fund in your plan. It includes the type of fund it is. You will see common terms like growth, growth and income, or capital preservation. It may tell you how the fund invests. It may own stocks, bonds, or real estate. And it will show you what the internal expenses are.

You also get a lot of information about the funds’ past performance. Many people will focus on these numbers.

Everyone Loves a Winner

We all like winners. It is easy to spot the funds which have big numbers. Who doesn’t want that fund with a five-year track record of 15% per year?

Is picking funds really that simple? Unfortunately, the answer is no. There have been studies that show past performance is not good at predicting the future. The most popular one is the Standard and Poor’s Persistence Scorecard. The report shows how many funds were top performers in the past that stayed that way in the future.

We looked at their most recent data (2019), and here are some interesting findings:

  • Only 3.84% of funds that were top half performers in 2015 remained top half performers over the next four years.
  • Only 21% of the funds that were in the top tier for five-year periods ending in 2014 remained top tier performers by 2019

Using past results has shown to be a very unreliable tool to pick your funds.

How to Pick Investments for Your 401k

Your primary focus should be on your asset allocation. This is the mix you have between stocks and bonds and other assets. Owning more stocks gives you greater opportunities for future growth. But it also means you will experience more short-term declines in your account values.

Bonds can reduce volatility, but they will not offer as much potential for growth.

As a general guideline, the younger you are, the more you should have in stocks.

  • If your retirement is 20 years or more from now, it is reasonable to have between 80 and 100% stocks in your account.
  • If your retirement is 15 years away, you may want to scale that back to between 70 and 90% stocks.
  • If you are 10 years from retirement, you may want to be 60 to 75% stock.
  • If your retirement is five years or sooner, you may only want to be 50 to 60% stock.

Costs Matter

Focus on low-cost funds. These are likely going to be funds that track a specific index like the S&P 500. You also may want to diversify by using large-cap, mid-cap, and small-cap stocks. Each of those will behave a little differently. International stock funds are also a good choice. Sometimes they do better than the US companies.

The same thing applies to bond funds. Use the lower-cost funds. Right now, you may want to avoid anything that has “long-term” in the name.

Keep it Simple

You can have too many funds, you should be able to build a good allocation with six or fewer funds. Some will even suggest only using four. In some situations, you can create a good allocation with only two funds.

If you would like to receive a second opinion about your 401k, choose a time on the calendar below.

Talk to a Certified Financial Planner™ Professional


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About the Author

Neal Watson is a Certified Financial Planner™ Professional and a Financial Advisor with Fleming Watson Financial Advisors.    He specializes in helping hard working, middle class families plan for retirement.

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