5 Things You Need to Know Before You Invest Your 401(k)
With rising costs of living and the uncertainty surrounding government benefits, it's more important than ever to invest in your 401(k) or other work-sponsored retirement plan. No one wants to deal with lean circumstances after a life of hard work and dedication. You already know the value of saving. The next step is learning about investing.
Chances are, your employer doesn't offer more than a couple dozen mutual funds for your consideration. To someone unfamiliar with investing, though, that can seem like an overwhelming number of options. Ultimately, you only need to choose 3 or 4 funds, and you should ideally direct 3% of each paycheck to allocate among those funds. Keep reading to learn about the factors you need to weigh in selecting the funds to safeguard your future.
1. Holdings
A typical mutual fund is made up of some proportion of stocks, bonds, and non-invested cash. Generally speaking - and certainly in your younger years - you want to invest at least 90% of your funds in stocks. Stocks are the fastest-growing investment, but be aware, it's also the riskiest (high risk = high reward). If you’ve got years of work ahead before you retire, you have time to wait for the market to recover from any downturns. As you close in on retirement, you might consider switching to a higher percentage of bond-related funds, which are typically safer, but yield lower returns.
2. Diversification of Your Investment Portfolio
There are three main classes of mutual funds: Large-cap funds (made up of companies valued at $10 billion or more), mid-cap funds (companies from $2 billion to $10 billion) and small-cap funds ($300 million to $2 billion). Since each company only fits into one of these classes, the easiest way to diversify your investments, and thus reduce your risk, is to choose funds from each of the classes. A good rule-of-thumb is to allot about 65% of your retirement contributions to large-cap, 25% to mid-cap, and 10% to small-cap.
3. Morningstar Investment Ratings
Morningstar, Inc. is an investment research firm that provides star-ratings for mutual funds. Their scale ranges from one star (poor) to five stars (must buy). Morningstar simplifies the selection process, and you can get a sense for a fund's prospects with minimal knowledge - in some cases, these things are best left to the professionals, like the experts at Morningstar. Where possible, you should choose funds with four or five stars.
4. Fund Family
While this may not be possible with the limited offerings of most employers, there are definite advantages to choosing funds from the same "fund family." If, for example, all of your funds are provided by "ABC Funds," then you're apt to receive reduced sales charges on your acquisitions when the total amount you have invested with ABC, in the aggregate, reaches certain "breakpoints" of value. Many fund families will allow you to switch from one fund to another in the same family without a sales charge. If you leave your employer and end up managing your retirement account independently, having your funds allocated in this way could well be beneficial over time.
5. Ongoing Performance
A solid performance record is good, but remember that past performance is not a guarantee of future performance, so you need to keep an eye on your investments and stay on top of announcements and projections. Above all, be mindful of each fund's performance as you march through the years. Too many investors simply park their 401(k) funds and never check back to see how they’re doing. You don't want to jump ship on a struggling fund too early, but if you find that you have a fund that's under-performing relative to the rest of the market for several years, it might be time to consider making a change.
Remember these principles, contribute consistently, and keep your eye on your investments, and you can enjoy your well-deserved relaxing, happy retirement.