Question: I have a 401(k) plan where I work. In the plan, there are about 20 investment choices. I would like to participate in the plan and contribute as much as I can afford, but I am completely baffled by the choices I have to make. Can you give me some advice on how to invest in my plan?
Answer: This is the second part of a two-part answer to your question. Last week, I discussed asset allocation, which is the way you diversify and spread your investments around in your account. This week I will tell you how to choose the actual investments that you will use to fill those asset classes.
If you followed through after reading last week’s column, you have figured out what asset classes are available in your 401(k) plan, you have determined what percentage of each asset class you want in your 401(k) retirement portfolio, and you are ready to select the investments.
Your next step is to make a list by asset class of the mutual funds that you have available. If there is only one mutual fund available in a particular asset class, then use that fund. If you have more than one fund available, then you’ll have to do some research. A good research website is www.morningstar.com. Here’s what to look for and how to compare funds:
- Track Record: The fund you choose should have at least a three year track record. Choose index funds where available.
- Stability: If the fund is a managed fund, meaning fund managers pick individual stocks and/or bonds, look for an experienced fund management team.
- Style Consistency: The securities in the fund should be consistent with the asset class, and the fund’s category and style box should be the same. Index funds fill this bill. Some funds will drift across styles.
- Expense ratio: Lower expense ratios mean you keep more of what the fund earns, so the lower the better.
- Alpha: This is a statistical measurement of fund performance that you can use to choose between funds. It tells you how well the portfolio manager is doing his job. The higher the better.
- Sharpe Ratio: This statistic measures how well you are being rewarded for taking the risk of investing in a particular fund relative to other funds. The higher the better.
- Performance: Although a fund’s past performance won’t tell you how well it will do in the future, you can use it to help you select between funds. Compare performance for the past 3, 5, 10, and longer years. 1-year performance isn’t very meaningful.
The criteria above should help you pick the best of the available funds in your plan. Now that you have your portfolio put together, be sure to contribute as much as possible each month. At least once a year, check the percentages. If your goals and risk tolerance haven’t changed, then rebalance your portfolio back to the original percentage allocation for each asset class. If your goals and/or your risk tolerance have changed, (for example, you are nearing retirement) then you can revise your asset allocation percentages and rebalance to these new percentages. Good luck!
Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment advisor and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning. Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA93940 or email them to firstname.lastname@example.org.