Smart 401(k) Investing—Investing in Your 401(k)
A Primer on Mutual Funds
Mutual funds are the most common 401(k) investments. They appeal to a wide range of investors for several reasons: They’re diversified, they’re professionally managed and they’re liquid, which means you can sell shares when you wish although you may have a loss if the fund has dropped in value.
Mutual funds fall into three broad categories:
- Stock mutual funds, which buy shares of stock in publicly traded corporations
- Bond mutual funds, which buy bonds issued by public corporations, by federal, state and local governments, and by federal agencies
- Money market funds, which buy a variety of short-term investments from various sources
When you get the list of funds your 401(k) plan offers, you’ll probably see a number of stock and bond funds. There may also be one or more balanced funds, which own both stocks and bonds, and one or more index funds. You may also be able to choose a target date fund, sometimes known as a lifecycle fund, or a managed account. Each choice has its own investment objective, management style, level of risk and fees.
Types of Stock Funds
Stock funds, sometimes known as equity funds, invest in a variety of ways. If you have a choice, it’s generally better to choose two or three funds buying different types of stock than to concentrate on funds investing in the same way.
One key difference is between growth funds and value funds. In brief, growth fund managers look for stocks whose prices they expect to go up as the companies’ products or services reach wider markets and their earnings increase. Value fund managers look for stocks that are seen as undervalued, or low-priced, because the company or sector is currently out of favor with investors. Value funds often outperform growth funds when the economy isn't strong. But there’s still a risk with value funds because not all companies recover from setbacks or recapture investors' interest.
Another important distinction is size, or market capitalization. Large capitalization, or large-cap, companies tend to be more price stable and less vulnerable to major losses than small-cap companies. That’s true in part because they have larger financial reserves. On the other hand, small- and mid-cap companies may have more growth potential.
You may find that the funds in your plan combine these designations, so you may have a choice between a small-cap growth fund and small-cap value fund, or between a large-cap growth fund and mid-cap value fund.
Your plan may also offer more narrowly focused sector funds, which invest in one segment of the economy, such as healthcare or utilities, or a contrarian fund, which invests in stocks other investors are shunning. Some plans also offer international stock funds, which invest in companies based in other countries.
Many 401(k) plans offer index funds as part of their investment menu, and these funds tend to be popular choices.
An index fund is designed to mirror the performance of a specific market index, such as the S&P 500 Index. If you believe that there’s no way for a mutual fund manager to consistently beat the market over the long term, you may prefer index funds to trying to select among managed funds.
In addition, index fund fees tend to be lower, sometimes significantly lower, than managed fund fees, because buy and sell decisions are based exclusively on changes in the composition of the relevant index so there’s no need for research or day-to-day investment decisions.
Of course, in a down market, an index fund will drop in value along with the index it mimics while some managed funds may achieve a stronger performance. That’s one risk of using these funds. Another risk is that many indexes—and therefore the funds that track them—are not as diversified as they seem. Because an index is typically weighted, a limited number of securities may determine the direction of the index. For example, the S&P 500 index emphasizes the performance of stocks with the highest market values.
Bond funds provide interest income from the underlying investments in the fund’s portfolio. While you’re investing in your 401(k), that income is reinvested to buy additional shares. Allocating a portion of your 401(k) contribution to these fixed income investments can play an important role in creating a diversified portfolio, reducing investment risk and helping you achieve your long-term goals.
You can differentiate bond funds from each other in two ways: by the types of bonds a fund owns and by the average term of the bonds in the fund.
Generally, 401(k) plans offer five categories of bond funds:
- US Treasury bond funds, which invest in bills, notes or bonds issued by the federal government
- Agency bond funds, which invest in bonds backed by a pool of mortgages and issued by either agencies of the federal government or government-sponsored enterprises
- Municipal bond funds, which invest in tax-exempt bonds issued by cities and states in order to fund public projects
- US corporate bond funds, which invest in bonds issued by US companies
- International bond funds, which invest in bonds issued by corporations based overseas or by governments other than the US
The average maturities of the bonds in a fund may be grouped as:
- Short term, with an average maturity of one year or less
- Intermediate term, with an average maturity of 2 to 10 years
- Long term, with an average maturity of 10 years or longer
The longer a bond fund’s average maturity, the more sensitive it is to changes in interest rates. As rates go up, the net asset value (NAV) of the fund drops. And as rates drop, the NAV increases.
From an investment perspective, what matters most is a bond fund’s total return. That’s the interest the underlying bonds pay, which is reinvested to buy more shares, plus any increase or decrease in the value of your principal. The greater the total return, the better your investment is doing.
A long-term bond fund has greater potential than a short-term bond fund to generate high total returns when rates are falling, but its total return is more likely to decline when rates are rising. The most volatile bond funds, called high-yield funds, invest in low-rated bonds with the greatest risk of default.
Balanced funds are the most truly diversified mutual funds because they invest in stocks, preferred stocks and bonds in order to provide both potential growth and current income. By holding both asset classes, balanced funds tend to be less volatile than either pure stock or pure bond funds.
The major drawback of a balanced fund may be that it tends to under-perform pure stock funds in a bull market because only a portion of the fund’s assets is invested in stock. The average stock allocation, which is typically about 60 percent of the total portfolio, is spelled out in the fund’s prospectus, along with any limits the fund manager must follow.
For example, a manager may have the right to shift investments in changing economic environments but be required to keep a minimum of 25 percent in stocks or bonds at any given time.
Changes in the current interest rate may also affect a balanced fund’s performance, especially if the fund is invested in long-term bonds in a period when interest rates are rising. That will tend to reduce the fund’s total return.
Stable value funds and guaranteed investment contracts (GICs) are designed to preserve capital. That means they make investments that have a low risk of losing money.
Stable value funds guarantee the value of your principal, which is your initial investment, and promise a fixed rate of return. They may buy US Treasury and corporate bonds as well as interest-bearing contracts from banks and insurance companies. Or all of the fund’s assets may go into GICs. GICs are insurance company products that resemble individual bonds or CDs—the issuer has use of your money for the term of the contract, and pays a fixed rate of interest in return. While it is highly unlikely a stable value fund will lose money, such as scenario has occurred.
Pros and Cons of Capital Preservation
Stable value funds and GICs typically pay interest at a higher rate than money market mutual funds. That’s one reason some investors who want to diversify a 401(k) account that contains more volatile investments, such as stock mutual funds, may choose these funds.
However, the interest rate on a stable value fund or GIC is generally guaranteed for only a predetermined time, sometimes as brief as three months, and varies with changing market conditions. Further, if you want to shift money out of the account, you may have to pay a penalty—sometimes a substantial one. That’s not the case when you move money from a stock or bond fund into another investment.
One downside of capital preservation alternatives is that they’re less likely to provide long-term protection against inflation. That can be a problem. You don’t want to find yourself short of the income you need in retirement.
For more information about how to select investments, see Choosing Investments.