Step 1 – Look at your options
When you’ve signed up for the 401k plan, review your options for investing your 401k. Look at the list of investments available – and from here you can take a shortcut if you like.
If your plan has a “target date” investment option that coincides closely with your hoped-for retirement date, start with that fund as your investment choice. This is an excellent place to start, especially when you have a relatively small amount of money in the plan. Choose this and you’re done – skip down to the “Follow up” section below.
If you’ve been participating for a while and have built up some money while investing your 401k, look at your options more closely. Among your options should be a large-cap stock fund (such as an S&P 500 index). In addition, there should be a broad-based bond fund as an option as well.
If there are multiple choices that fit those two categories, look a bit closer. Somewhere in your documentation should be information about the expense ratios of the funds. Choose the large-cap stock and bond fund with the lowest expense ratio when there is a difference.
There will likely be other investment options available to you, but for simplicity’s sake, you should just stick with these two for the time being. As you build your experience investing your 401k plan, add other investment choices to the mix.
Note: if you’re still overwhelmed, look at “Follow up” below for information about advisors to help you with the process.
Step 2 – Consider your risk tolerance
Risk tolerance is a fancy term that we financial-types use to describe how much you can stand the ups and downs of the market when investing your 401k funds. If you’re a nervous investor, watching your balance every day or week, you have a low risk tolerance; if you are a “set-it-and-forget-it” type, your risk tolerance is higher. Stocks are (generally) the more risky investment versus bonds, so if you have a lower risk tolerance your stock investment should be a bit lower. Vice versa if you have a higher risk tolerance.
Generally, when choosing between the two options we outlined above (stock and bond funds), you should select a ratio of no less than 25% of either, and the remainder of your selection should be no more than 75%.
A good starting point is 50% in each of the stock fund and the bond fund. If you’re really skittish about investing your 401k, and/or there are only a few years remaining before your retirement date, you might choose to invest a bit less in the stock fund and more in the bond fund. On the other hand, if you’re okay with the market’s up and down movements and recognize that investing your 401k is a long-term activity, investing more in stocks and less in bonds may be the better choice.
If it seems like I’m vague about this part, that’s because this part is personal and can be different for each person. Without knowing your circumstances, I can’t tell you how to invest. However, as a rule, it’s better to put more in stocks than in bonds, as this will give you a better chance of experiencing growth of your 401k plan over time. If you start out skittish and become more comfortable, you can always increase your stock investment later on.
Follow up – investing your 401k
After you’ve had some experience investing your 401k funds, you may become more comfortable with the process. Even if you’re not comfortable with it, it does pay off to review your investment options again over time. Especially if you chose the target date option above, you may want to adjust your investment process over time.
Your employer may offer access to a service to guide you through the process of investing your 401k. Take advantage of this service if you have it available.
In addition, there are plenty of books that can help you with the investment process. You’ll never regret educating yourself on investing. If it’s just not your thing, you can choose to find an advisor to help you with the follow up process. There are many advisors who can help you look over the options for investing your 401k. Many do this for an hourly fee. Even if it costs you $500 to $1000 to get this advice, it’s money very well spent. The advisor will help you understand what’s going on with your 401k.
Two good options to find advisors are the Garrett Planning Network and the National Association of Personal Financial Advisors (NAPFA). Click on the link to go to each website for more information.