How to Invest Your 401K Funds

In my role as a member of my company's 401K committee, I have recently had conversations about the topic of 401K asset allocation with a number of people in my company. I discovered that people don't really know how to invest their retirement money. Below are some of the poor investment strategies that I have heard about:

Pretend Diversification - one employee told me that his investment strategy is to split his contributions between all available fund options. Since we offer our employees a total of 15 funds, he essentially puts 6.7% of his funds in each of them. What a horrible strategy. Essentially this employee believes that whatever it is we put in front of him is worth spending money on, regardless of cost or performance. That's not diversification, it's laziness. Such laziness makes me want to roll up a newspaper, smack that guy on the nose and yell, "No! Bad investor!" This is probably the second worst 401K investment strategy that I have heard about. Here is the worst:

Putting Your Money in the Safest Investment - one employee puts most of his money in the stable value fund offered in our plan. He thinks he is doing himself a favor by playing it ultra conservative. This is a poor strategy. A 401K is a very long term investment. Arguably it is the longest term investment most people make. That being the case, the daily, monthly and even annual ups and downs of the market are not relevant. All the matters are the long term trends, and in the long run stable value funds barely keep up with inflation. Try to be too conservative with your money and you are bound to end up with a cash stash too small to support you comfortably in retirement.

Over Confidence - more than one employee told me that they are investing their money in only one or two funds. Unless you are talking about a lifestyle fund, or a couple of very broad based index funds, you are probably not going to get the diversification you need from such a small number of funds. You may feel confident about the hotshot international equity fund you picked, but without sufficient diversification you'll be sorry when the next international melt down hits.

Not Paying Enough Attention to Cost - few employees demonstrated to me an understanding of the costs associated with the investments that they picked. That's too bad for them. Costs can have a critical impact on your portfolio. Let me give you an example: let's say that your equity fund generates an average return of 8% a year. If your fund charges an expense ratio of 2%, you are essentially paying a commission of 25% on your profit! And don't think I am exaggerating either. Our 401K plan has more than one fund that carries that expense ratio. That's partly the reason that we are switching 401K plan providers.

So how should you invest your retirement money? Here are a few tips:

1. If You Don't Know Ask - ask your plan's sponsor or call a financial advisor directly. Better yet, go online and read some personal finance blogs for some hints. Go to the library, get a few books and read. Whatever you do, educate yourslef before you commit to any investment strategy.

2. Consider the Costs - very few investment options are worth 2% per year in fees. I am a big proponent of index investing. If your 401K plan offer a broad index fund, check it's expense ratio and consider investing some of your money in that option. Generally speaking, if you are given the choice between two funds that cover the same asset class, you probably want to pick the one with the lower cost. Studies have shown a negative correlation between investment fees and investment returns: the more you pay, the less you get for your payment. What a scheme.

3. Diversify for Real - Don't just select multiple funds. Select funds that cover different asset classes. Get a broad exposure to the domestic stock market, the international stock market and to the bond market. If you can add a small exposure to the real estate market, that might not be a bad option either.

4. Consider Lifestyle Funds - lifestyle funds are an excellent option for investors who feel that they don't know enough to invest for themselves or that don't want to deal with the hassle. All it takes is for you to pick your retirement date, put in your money and the fund invests your assets in a mixture of stocks and bonds that gets progressively more conservative as you age.

5. Stay Out of the Money Market Fund or Stable Value Funds - such funds are great if you are building an emergency cash reserve or saving for your summer vacation, but if your investment time horizon is long, putting your money in such vehicles is a poor decision.