To make choosing easier, begin by grouping the available funds.
- Stock funds include large-company stocks (including ”growth and income” funds), small-company stocks (including ”aggressive growth” funds) and international stocks.
- Bond funds are categorized by length of the bond — such as short-term, intermediate or long-term — and by the kind of bond, such as government, corporate, high-yield or international.
- Stable-value funds are sometimes called GIC, guaranteed-income or money funds. (Of these stable-value choices, IRA investors will generally have access to money market funds.)
- Balanced or asset-allocation funds consist of various mixes of these investments in a set percentage.
Understand your time horizon
If you’re years from retirement, investing most of your money in stock funds makes sense. But if you plan to borrow from your 401(k) plan soon, that portion should be in stable-value funds, so you don’t have to liquidate stocks or bonds that have gone south in a sour market.
Understand your risk tolerance
Stocks are more volatile than bonds, and bonds are more volatile than stable-value funds. Volatility is what we mean by risk.
If you have 10 years or longer before you retire, stock funds will reward you with higher returns even though your plan value may dip at times, so you should invest at least 80 percent of your plan in stock funds.
If you are less than 10 years away from retirement, or if you are deathly afraid of losses, pare your stock investments, but don’t eliminate stocks entirely. A mix of 30 percent stocks and 70 percent bonds is actually less volatile than 100 percent bonds. Most 401(k) participants should invest at least 60 percent of their funds in stocks.
Once you have decided the percentages for stocks, bonds and stable-value funds, it’s time to pick the best funds.
Let’s say you want 80 percent stocks and 20 percent bonds. Gauge the three-year performance of the funds and pick one stock fund from each of the major categories: one large cap (or S&P 500 index) fund, one small cap (or aggressive-growth) fund and one international fund. Then pick an intermediate bond fund and a high-yield bond fund. Allocate your investments among the funds: 30 percent large cap, 30 percent small cap, 20 percent international, 10 percent intermediate bond and 10 percent high-yield bond. You are now fully diversified with just five funds.
If you choose a balanced or asset-allocation fund, most of the diversification is contained in one fund.
If your large cap stocks now comprise 40 percent of your 401(k) assets instead of 30 percent, reduce your large cap contributions and beef up contributions to an underweighted category.
Every investment has its season, and by investing in categories that are trading for less, you will be following the old adage ”Buy low, sell high.”
- Categorize your options
- Understand your time horizon
- Understand your risk tolerance
- Reallocate annually