401k investing is the most common way for young investors to get involved with retirement savings. But the problem with 401ks is that every employer has its own plan, with its own list of mutual funds to pick from.
That makes it very difficult for young investors to know what to pick, because similar funds can look very different depending on how they are named or the jargon used in your benefits kit.
So here’s a simple primer on five major flavors of funds you’ll have to pick from:
These cover a host of stock types — there are funds that focus on smaller stocks, funds that focus on large and established stocks, funds that focus on international stocks — so they can be confusing. But take the time to explore the various stock funds in your 401k because young investors should place the lion’s share of their retirement funds here.
A general rule of thumb for the average investor is to take 100, then subtract your age — that’s your stock allocation for your portfolio. So if you’re a young investor around 30, you should be 70% in stocks and 30% in bonds, typically. If you’re more aggressive, you might want even less than that in bonds to grow your money faster.
How to allocate that money around the stock universe is simple: Stick with large, U.S.-based stocks to play it safe or dabble in smaller stocks or international picks depending on how aggressive you are. Most 401ks only offer a handful of stock funds to choose from, so selecting funds in this category shouldn’t be hard — just look at expenses (lower is better) and long-term returns (higher is better) to find the best fit.
A no-fuss way to invest, target-date 401k funds tend to have a year in them — say, 2030 or 2045 — and this is theoretically the “target date” for your retirement. These funds are simple and adjust your asset allocation over time, so there’s no need to rebalance on your own — making them a maintenance-free way to invest. However, sometimes expenses and fees can be higher than the alternatives, so watch out for costs.
And remember: These target funds are one-size-fits-all — so if you want to take a little less risk or be a little more aggressive, these vehicles are inflexible and might not be for you. But hey, something is better than nothing.
This is like a target-date fund in that it blends stocks and bonds. But unlike a target date fund, these investments have a set ratio of stocks (more risky with higher returns) and bonds (less risky and lower returns).
Going back to the age rule discussed above, if you’re a young investor around 30, it is likely a bad idea to put your cash in a blended fund that is split 50/50 between stocks and bonds. Based on your age and the amount of money you need to have by retirement, that strategy is too conservative and won’t grow your money fast enough. Pay close attention to the blending ratio to see if these sound right for you — as well as the expenses that come with managing a portfolio mixed between stocks and bonds.
These are typically “capital preservation” instruments, meant to safeguard money rather than grow it. If you’re older than 50 and have a decent nest egg, managed-income funds are a good way to grow your money a little bit and protect it from losses. But if you’re younger and are a long way from your retirement savings goal, you can’t afford to only make a few percentage points per year, or you’ll never have enough to retire.
Remember this — because parents frequently recommend their kids allocate a decent amount to bonds in their first 401k because that’s where they are in their retirement planning. Your finances and goals are much different, and if you’re under 40, it’s unlikely bonds and managed income should play a large role in your portfolio.
Money Market Funds
A money market fund is essentially a glorified CD, and an alternative to cash. The only circumstances where it makes sense to your money here is if you have achieved your retirement goals and simply are looking for a safe place to park your cash — because there is zero growth here. Returns of about 1% a year mean that money market funds barely keep up with inflation — so if you want to grow your money instead of just socking it away, avoid money market funds.
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at firstname.lastname@example.org or follow him on Twitter via @JeffReevesIP.