Company 401(k)s are easy options for many people to begin saving for retirement. They’re not just easy, they’re super easy and convenient!
However, deciding which funds to invest in is quite another issue.
Most of the time, employers set you up with a default fund, usually a “target date” fund (which I’ll get into in a bit).
Although those funds are not bad for getting started, I don’t necessarily recommend keeping your money there; it might be worth seeing what other options are available to you.
That’s really the big issue here: “What funds should you invest in?”
But first, let me say a few things about company 401(k)s and why I think they’re important.
First, it’s usually the case that employers match up to a certain percent that you contribute, and that is great! That’s free money invested for you, and you will never beat free!
Basically, that’s 100 percent return right out the gate, so you don’t want to miss out on that. That’s why I always recommend contributing up to at least the company match.
For me, that’s 6 percent. My employer matches dollar for dollar up to 6 percent, which is pretty substantial!
Second, they’re super easy to start. As I said, even if you are unsure about which funds to invest, your employer will pick one for you to get you started. This makes investing immediate and convenient.
Immediate in the sense that you begin investing right away out of your paycheck (this also allows you to defer paying taxes on that amount), and convenient in the sense that you don’t even need to think about it (it’s automatically done for you).
This gives you quick and easy exposure to the stock market, which is what matters most when trying to build wealth and retire (you want to start soon and invest for as long as possible).
It’s worth noting that 401(k)s are one of the most common ways in which millionaires accumulate their wealth. So they’re a pretty big deal. What’s great is that they are available to almost anyone.
If you change careers or jobs, it’s easy to simply rollover your investments to the next one (since almost every employer worth working for has one).
Now let’s return to the question of which funds to invest?
Now that we see the importance of 401(k)s, let’s make sure we invest in the right options.
Rather than talk about funds that may or may not be available (depending on the company you work for), perhaps it’s best to first know what to look for.
Here’s what I try to do when deciding on funds in a company’s 401(k).
1. Avoid target date funds
First and foremost, avoid target date funds.
A “target date fund” is a fund that anticipates the year you will retire. As you approach that date, the fund automatically becomes more conservative by reallocating more shares in bonds while investing less in stocks.
As I mentioned earlier, target date funds may not be the best option for your money. That’s because target date funds hold shares in bonds, and bonds are not the best option for your investments.
Some people think bonds are safe, but safe comes with a hefty price – they will literally hurt your returns.
You will not come close to the same returns in bonds as you would with stocks, so having any amount of money invested in bonds at all is going to hurt your overall rate of return.
I recommend having no money invested in bonds, so target date funds are out! That basically means I only recommend funds invested in stocks, which brings me to my next point.
2. Go with stocks
When investing in a company’s 401(k), remember that you do have options. You don’t have to settle with the target date fund that most people go with.
More than likely, your company will offer other options. At the very least, it’s worth looking at those options to see if there’s something better.
One option that would most likely be better is a fund that is invested in 100 percent stocks.
Yes – 100 percent stocks!
That might sound crazy to some people. But like I said earlier, stock funds are going to outperform the others.
If your company offers a fund that is 100 percent invested in stocks, the next thing I’d do is see whether or not it’s diversified, so let’s look at that.
3. Get diversified
There seems to be a lot of confusion about what is meant by “diversified.”
When I say get diversified, I don’t mean that you have to have bond funds, obviously, and I don’t mean that you have to have international funds either (I don’t have either).
You can be plenty diversified with only domestic stock funds – which is what I recommend.
But how is that?
It all depends on the type of stock funds (and companies) a particular mutual fund has.
In domestic stocks alone, there are small-cap, large-cap, and medium-cap companies. Among those, there are different sectors (banking, transportation, manufacturing, etc.). In addition to that, there are some stocks that only grow in value (growth), and there are others that pay dividends (income) – sometimes a combination of both (growth and income).
For example, if you have a single fund in only domestic stock that invests in medium and large-cap companies across many different sectors, I’d say that’s pretty diversified. You’re not putting all your eggs in one basket. That is to say, you’re not betting all your money on one specific size and type of company.
Even if you were to invest in a single fund with only large-cap companies across many different sectors with some in growth and some in growth and income, such an investment is still diversified.
Diversification can occur in many different ways – through one fund or multiple funds, through one type of company or multiple types of companies – the options are endless.
Since I mentioned international funds earlier, I better say something about those now.
Sure you could invest in international stocks and domestic stocks, and think you are more diversified, but that’s not necessarily a good idea. The problem with international stock funds is finding ones worth investing in.
Sure there are good international stocks out there, but in my experience, company 401(k)s usually don’t have good international options (you’ll find that domestic stocks are usually the way to go).
So how do we know whether a particular fund is a good option or not?
The answer, I think, depends on how well the fund compares to the overall market. Or to put it another way – does it beat the S&P 500? Here’s what I mean.
4. Beat the S&P 500
The S&P 500 is an index comprised of the top 500 companies in the world. If you want to get a good idea of what the market is actually doing, look no further than the S&P 500 index. If the S&P 500 goes up, that means the market went up.
So if you have a 401(k), the chances are your 401(k) goes up when the S&P goes up. The reason for that is because you’re probably invested – via mutual funds in your 401(k) – in a lot of those companies that are in the S&P 500.
The S&P 500 has always been a good way to assess what the stock market is actually doing. So a good way to measure a particular fund in a 401(k) option is to see how well it compares, historically, to the S&P 500. This is very easy to do.
When looking at different fund options in a company 401(k), the idea is to make sure it matches (or even beats) the S&P 500. Historically, the 30 year return of the S&P 500 has been about 12 percent.
Now most funds will likely not have a 30 year track record, but obviously, you can check the record that they do have. I would look at funds that have at least a 5 year track record (preferably a 10-15 year track record) to see if it matches (or even beats) the S&P 500. If it does, I’d say that’s a fund worth having.
An example from my 401(k)
To give you an example of a fund that meets the recommendations I gave, I’ll give you an example from my own personal 401(k).
Now, my company uses Fidelity, so the particular fund I use may not be available to you, so keep that in mind.
You just have to do the best with what you got, or with the options that are available to you. As long as they meet the recommendations, you’re good to go! You can be confident in the fund(s) you choose.
The particular fund I use in my 401(k) is the only fund I use by the way. It’s the William Blair Small-Mid Cap Growth Fund (WSMDX).
Let’s make sure it meets the recommendations listed above.
- It’s not a target date fund.
- It’s 100 percent stocks with no bonds.
- It’s diversified.
- It beats the S&P 500
To take a closer look, let’s start with what the fund aims to achieve:
Since it invests in both small-cap and mid-cap companies, diversified in equity securities and other equity investments, we can say that it is plenty diversified.
Here is how it measures up to other funds of its type:
This chart is a hypothetical growth of $10k over a 10 year period. You can clearly see that it has outpaced the other funds of its type.
Here is another chart of a hypothetical growth of $10k over a 10 year period – this time comparing a target date fund with the S&P 500:
What’s interesting about this chart is that you are able to see how the S&P 500 outperforms target date funds. But what’s more revealing is that – even though the S&P beats target date funds – it falls short of beating the WSMDX.
As you can see, the WSMDX shows something north of $40k on it’s hypothetical growth, while the S&P 500 shows something below $40k.
The WSMDX is the clear winner! It beats the S&P 500, target date funds, as well as other funds of its type.
Since the MSMDX meets all the recommendations, I concluded that it was a fund worth having.
Investing in a company 401(k) doesn’t have to be complicated. In fact, it can be pretty easy. There are only a few things to keep in mind when it comes to choosing the right investments.
While target date funds are convenient and don’t require you to do much of anything, they are not always the best place to park your money. You may want to see if there are better options available to you. As long as you know what you’re looking for, you can have confidence on whether or not a particular investment is good or not.
If you find yourself invested in a fund (or combination of funds) comprises of stocks (no bonds), whether domestic, international or a combination of both – if those funds hold shares in companies of different sizes and sectors that match or beat the S&P 500 – I’d say you’re in a pretty good fund.