Ok, you’ve got a 401(k) set up. Needless to say, your plan is only as good as what you do with it.
Ideally, you’re contributing the maximum your budget will allow (or at least getting the employer match, if there is one).
But you should also pick investments that balance your tolerance for risk with your expectations for growth.
Mutual funds are the most common investments available in 401(k) plans. But not all funds were created equal. When choosing which ones to invest in, ask the following four questions:
What type of fund is it? Is it actively managed (by a team that seeks to outperform certain benchmarks) or is it a so-called passively managed fund, i.e. the fund mirrors a set of similar stocks or bonds in a group commonly called an index (like the Dow or the S&P 500).
Most actively managed funds don’t beat their respective benchmarks (according to a 2012 S&P study). Examine the fund’s performance for the past year as well as over the past five and 10 years, if the fund has been around that long (it’s arguably better to stick with funds with longer track records).
How much does it cost? All funds charge a fee called an expense ratio. Remember that your return will be less the cost of the fund. Let’s say you’re paying a 0.5% expense ratio, and it showed a 5% gain last year; you pocket 4.5%.
Given the statistics on actively managed funds, their higher expense ratios may not be worth it. Probably better to stick with a blend of lower-cost index funds and exchange-traded funds, if available.
What’s the fund manager’s tenure? Managers often hop from place to place like professional athletes. The hot ones get recruited by other companies and others get cut for underperforming.
If you’re going with an actively managed fund, a longer tenure (three to five years) indicates that the performance has been solid.
What’s the Morningstar rating? Morningstar is a leading provider of independent investment research and best known for their “star rating” system. Four- or five-star funds have a history of strong risk-adjusted returns for a reasonable cost.