A Guide to Choosing 401(k) Mutual Funds and Asset Allocation

Many times, people ask me for advice on how to choose which mutual funds in their 401(k) to select and how much they should allocate to each of them. In writing this, I am assuming that the 401(k) in question offers a variety of mutual funds, specifically, a large cap fund, a small cap fund, a bond fund, an international fund and a money market fund.

If you are financially savvy, you should first consider if it makes sense to contribute to your 401(k) in addition to, instead of, or only when an IRA account has been fully utilized. There are a lot of considerations when making this decision and plenty of financial calculators to help make this decision. Also, you should consider the quality of the funds offered in your plan. How have they performed in relation to their peers over the long-term? How is the fund manager? Has anything changed? How do the funds expenses compare to industry standards? If your employer offers any type of match, it is almost a given that you should contribute to your 401(k) to the point of maximizing the employer's match. After all, this is FREE MONEY, and higher-expenses and lower returns usually can't undo this benefit.

For the less financially savvy or those who struggle with the discipline to invest regularly, investing in your 401(k) is the easiest way to put aside some money. After all, if you never see the money in your paycheck, you can't spend it! However, how do you choose which mutual funds to utilize and how much to contribute to each? The guy in the next cubicle just said that the International fund has done well this year-should you go "all in", as he so eloquently put it? NO!!!

The first thing you should do is determine a mix of stocks, bonds, and "cash" investments suitable for you that balances your risk tolerance with your need for long-term appreciation. See, the more concentrated you are invested in stocks, the greater the likelihood your will achieve higher returns over the long-haul. However, you'll be subject to price fluctuations-often times wildly! If you concentrate your portfolio in safer investments such as money market funds, you will have more stable balance, yet one that will probably under-perform and be eroded away by inflation over the long term. When having this discussion with people, the first thing I ask them is what they would do if they invested $10,000 in the stock market and saw their account fall to $5000 overnight. If they react with a panic-stricken deer-in-the-headlights glazed look, their risk-tolerance is low. However, if they slyly grin and start shouting "BUY BUY BUY", I realize they have a high-risk tolerance. I will give model portfolios for each of these extremes, but most people fall in between these two polars. Judge for yourself whether you are closer to one end of the spectrum or the other, and adjust accordingly. Keep in mind that most people with whom I have this discussion are nowhere near retirement age. If you're planning on retiring in the next 10 years or so, your portfolio should be a little closer to the conservative end of the spectrum.

The first portfolio is for the risk-avoider. They want to be able to sleep at night without worrying about wild swings in the value of their savings. However, they also need to understand that stocks still need to represent a significant part of their savings to provide investment income that inflation can't erode away. We'll try to minimize the wilder fluctuations while still capitalizing with stocks. Stocks should be the core of the portfolio, but should be around 60%. That 60% should also be divided up between large cap, small cap, and international stocks. 30% (of the overall account) invested in large-caps will provide growth with the stability of some of the most well-established companies. These companies have deep-roots and can survive most anything. 20% should be invested in international stocks. While the United States is one of the largest economies in the world, it still has ups and downs that may not match the rest of the world. Spreading out investments across the globe will help smooth out the effects of the US economy. The last 10% should be invested in small-cap stocks. These stocks are the most volatile, but should not be ignored in any portfolio because they have the potential to provide the best returns. Once upon a time, Microsoft, Wal-Mart and Target were small-cap stocks and those investors savvy enough to recognize their potential early on have been richly rewarded. 30% should be allocated to bond funds, preferable with intermediate to long maturities. These should provide a higher dividend yield with a potential for some capital appreciation. The final 10% should be invested in a money market fund. The money market fund should not stray from $1.00 a share and will provide a degree of interest income.

The other end of the spectrum would be the aggressive portfolio. I would recommend 80% stocks that should be divided into 40% large-cap, 20% small-cap, and 20% international. The remaining 20% should be invested in bonds.

Keep in mind that these portfolios are for the conservative and aggressive investor. Most people fall somewhere in between, so you should tailor something a little more specific to your preferences. These portfolios are merely my suggestion, and by no means constitute an sure-fire way to succeed. I'm not a professional financial advisor; if you are seeking professional financial advice, my best suggestion is to contact a professional.