by Tom Doan
If you have set up a 401k plan with your employer, you will notice that you cannot invest in everything available in the stock market. Typically you can only pick from a select list and allocate 100% of the contributions among them. The selections are limited because the 401k plan goes through an administrator, and each plan has a different list of investment vehicles available to the plan participants. To some, looking at the list and figuring out which funds to pick may seem as clueless as finding a light switch in a foreign room. By the end of this article, aligning its contents with your own financial situation will allow you to navigate the room as if it were your own.
The name of the fund will provide you with an idea of the risk level and diversification within the fund itself. The funds will contain a basket of stocks and/or bonds managed by a fund manager, whose firm is most of the time the first part of the name. They will typically invest in a certain area that will be pointed out in the fund name. One common area is market capitalization. Large-cap funds usually have companies that are valued over $8 billion and are viewed as a long-term holding. Mid-cap funds are geared towards companies in the $1 to $8 billion threshold and tend to be a little more volatile than large-cap funds but not as much as small-cap funds. Small-cap and micro-cap funds have companies that are less than $1 and $250 million, respectively. Both of these funds can be very volatile, especially since micro-funds are likely investing in startups and much smaller companies.
In addition to market capitalization, funds can also be categorized by the company goals such as growth, income, and value. Growth stocks will invest in stocks that usually do not pay dividends and reinvest everything in order to grow at a quicker rate than the market. Income or dividend stocks can experience lower levels of volatility and provide a steady stream of income. Value stocks are companies where the investor believes the stock is undervalued judging from its financial ratios, earnings, and financial statements.
Funds also sort by the location and/or sector of the securities. Titles such as “international,” “Russian,” or “healthcare” are all self-explanatory. Emerging markets invest in countries that are still developing its commercial base and have a very high growth ceiling along with higher risk.
Bond funds, as its name suggests, contains bonds. However these are also classified based on the type of bonds such as municipal (states and local governments), corporate, treasury bonds (US bonds with a maturity of greater than 10 years), treasury notes (US bonds with maturities from one to ten years), or treasury bills (US bonds with a maturity of less than one year). The yield structure is also often noted. Since there is a direct relationship between the riskiness of a bond and its yield, a “junk bond” or “high yield” bond fund is riskier than an “investment grade” or US bond fund.
Some funds make it easy and have a set security allocation based on your retirement goal, such as a “target retirement 2030” fund. This fund will allocate its positions based on an average person with the timeframe of retiring in 2030. As a result, if you like the target year fund but are more risk averse, you can select a target date with a shorter timeframe, such as a 2020 fund.
Our approach towards 401ks is to lower expense costs by avoiding actively managed mutual funds and investing in passively managed index funds. For more information, you can access our free 401k course on our website by clicking here. Morningstar is another great tool you can use to look up funds and find helpful information such as expense ratios. Knowing the risk factors of the funds, you can then select the funds most appropriate for your financial goals to flip the switch and have light shine down on your path towards retirement.