Apr 29th, 2008
Picky, Picky: What Funds For a 401(k)?
It’s likely that your 401(k) will be your largest investment account. Knowing that, it’s prudent to determine what asset allocation you want in that account, as well as what mutual funds you’d like to be included.
We’ve discussed asset allocation before; basically it’s how much money you would like in certain kinds of investments. I’ve pretty much standardized on a mix of 50% domestic stocks, 25% high quality bonds, and 25% international stocks. This makes the math easy and builds you a fantastic portfolio with just three funds. If I was very close to retirement (or in it) I’d likely be closer to 35% domestic stocks, 15% international stocks, and 50% high quality bonds, but your mileage may vary. This is, in fact, the way my portfolio is currently constructed.
In an ideal world, I’d construct this portfolio with these three funds:
Vanguard Total Stock Market Index (VTSMX)
Vanguard GNMA Fund
Vanguard Bond Index
That said, there are many, many fine mutual funds out there, and your 401(k) plan may not offer the ones you want most. In my case, they only offer one of the three funds, so I have substituted a couple of other funds [given that my plan, which is actually a 403(b) because I work for a non-profit, has a brokerage option which I am still investigating, I may in fact someday get exactly the funds I want]. In any case, my first choice for the portfolio in principal would be low cost, passively managed, no load index funds–while Vanguard is the king of these, there are many alternatives such as T. Rowe Price, Fidelity, and TIAA-CREF.
While I am not a fan of actively managed funds, if you for some reason do want to include them in your investments, the best place to keep them is in a tax sheltered account of some kind like a 401(k). The reason for this is that these funds tend to generate taxable capital gains every year which are much larger than the negligible capital gains generated by passively managed funds, so if you for some reason want to have a few actively managed funds in some segment of your total holdings, this may be the place to do it (this concept is known as asset location, which is similar to but definitely not the same as asset allocation). I would, however, totally recommend staying away from load funds–there’s no reason to pay a load, ever.
One other issue to consider is your employer match. If your employer matches you using the stock of the company you work for, it is quite likely you will quickly become overweighted in your company stock. This becomes one of the basic issues of diversification; all is well while the company is doing well, yet if the company falls on hard times (Bear Sterns, anyone?) so will your portfolio. Strive to keep your own company stock under 5% of your total if at all possible.
Thinking about what you will have in your 401(k) is almost as important as starting it in the first place. Consider asset allocation, asset location, and diversification while working on this aspect of your portfolio and you will do just fine–with only three funds, too!
