How to Evaluate Your 401(k) Options

Comparing funds for your retirement

When it comes to investing via your 401(k) plan, you can make things as simple or complicated as you like. Some people spend hours researching investment strategies and asset allocations, trying to maximize their gains. Others are content with the slow but steady growth offered by target-date funds or broad-based index funds.

No matter which strategy you choose, there will more than likely come a moment where you’ll have to choose among seemingly similar funds. Let’s look at how you can assess them and make comparisons.

Key Takeaways

  • Well-designed 401(k) plans offer a huge range of investments. No matter which investment strategy you pick, you’ll likely have to choose among a number of similar funds. 
  • You should look for funds with low fees and a risk-reward profile that matches your preference. 
  • You can also make use of Morningstar’s star ratings to help you decide among funds; however, be careful not to let it dominate your thinking. 
  • Finally, take a look at the past performance of a fund while keeping in mind that short-term performance is an unreliable guide to long-term returns.

Choosing 401(k) Funds

To begin, we’re going to assume that you understand the basics of how investing in a 401(k) works and have some idea of what strategy you would like to follow. The succinct advice is to make sure that your portfolio is balanced—meaning that it contains a mixture of asset types. This is known as your asset allocation and is generally split among domestic stocks, international stocks, and domestic bonds. As you get closer to retirement age, the standard advice is to gradually reduce the risk in your portfolio by reducing your exposure to stocks. A target-date fund will do that for you, automatically.

Even with the simplest investment strategies—for example, a target-date fund or a portfolio split between an S&P 500 index fund and U.S. Treasury bonds—you will have decisions to make. Intelligently structured 401(k) plans offer a huge range of funds for investment, so even if you are looking for a simple tracker fund, you may have five or more options available. At this point, there are two basic assessments that you can make.

First, look at the fees associated with each fund that you are considering. When choosing investments for your 401(k), avoid funds that charge high management fees and sales charges. Index funds generally have the lowest fees, because they require little or no hands-on management. These funds are automatically invested in shares of the companies that make up a stock index, such as the S&P 500 or the Russell 2000, and they change only when those indexes change. If you opt for well-run index funds, you should look to pay no more than 0.25% in annual fees.

Second, consider the risk that each fund represents to the value of your portfolio. Funds—even those focused on the same asset class—can be put on a spectrum from low-risk, low-reward funds to high-risk, high-reward funds. If you’ve decided to invest 30% of your portfolio in stocks, you can do this via high-risk stock funds with potentially higher returns or low-risk, low-return funds. This consideration is a highly personal one and known as your risk tolerance. Only you are qualified to say whether you like the idea of taking a flier or prefer to play it safe. 

Even if you spot some great new investment options for your 401(k), make sure that you keep your portfolio balanced. Diversification helps you capture returns from a mix of investments—stocks, bonds, commodities, and others—while protecting your balance against the risk of a downturn in any one asset class.

Comparing 401(k) Funds

There are also more sophisticated methods for assessing your 401(k) options. A number of companies and websites assess the funds available in a 401(k) and claim to be able to identify well-performing funds.

Arguably, the most well known of these sites is Morningstar. You can look up a fund there and see detailed information on it. This will include its assets, historical performance, and even a star rating. This rating appears to offer a simple way for investors to choose funds, but don’t be fooled. There are concerns that the ratings are misleading, and research has suggested that they are not always a reliable guide to performance. However, since then, Morningstar expanded its star rating system with three additional systems to measure funds and their performance, looking at both the forward-looking qualitative and quantitative as well as backward-looking quantitative. Even with the additional analysis, take care not to rely too heavily on any one source for investment guidance.

The most complex assessment you can make is trying to predict the returns of a fund based on past performance. The bad news here is that this is almost impossible in the short term. However, if you look at the performance of a fund over at least the past 10 years—and, ideally, longer—you may get a sense of the average returns that it has offered over that period. If all else is equal—if two funds have the same fees and roughly the same risk exposure—go for the better-performing fund.

What is the safest 401(k) investment?

The least risky investment in a 401(k) would be either money market funds or U.S. Treasury bonds. However, these investments will typically offer a very low rate of return and may not keep up with inflation.

Can you lose money in a 401(k)?

Yes. Because your 401(k) will be invested in various assets (stocks, bonds, etc.), your portfolio will be exposed to market risk. If the stock market drops, the stock component of your portfolio will also go down in value. This is why you should move a growing proportion of your money into safer investments as you approach retirement.

What can I add to my 401(k)?

The most common investment for 401(k) plans are mutual funds, though some are starting to offer exchange-traded funds (ETFs). Both mutual funds and ETFs contain a basket of securities, such as equities.

The Bottom Line

A well-designed 401(k) plan should provide you with a wide array of investment possibilities. Regardless of which investment strategy you select, you’ll probably have a myriad of similar funds from which to choose. 

Start with low-fee funds that have a risk-reward profile with which you are comfortable. You can also make use of Morningstar’s star ratings to help you decide among funds, but you must not rely on them excessively, as their track record is mixed. Finally, take a look at the past performance of a fund while keeping in mind that short-term performance is an unreliable guide to long-term returns.

Article Sources
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  1., U.S. Securities and Exchange Commission. “Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing.”

  2., U.S. Securities and Exchange Commission. “Index Funds.”

  3. Investment Company Institute. “Trends in the Expenses and Fees of Funds, 2021,” Page 15.

  4. Morningstar. “How to Read a Morningstar Fund Analyst Report.”

  5. Morningstar. “Rating Morningstar’s Fund Ratings.”

  6., U.S. Securities and Exchange Commission. “Updated Investor Bulletin: Focus on Money Market Funds.”

  7. Financial Industry Regulatory Authority. “U.S. Treasury Securities.”

  8. Fiscal Data, U.S. Department of the Treasury. “Average Interest Rates on U.S. Treasury Securities.”

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