Investing your 401k money appropriately is harder than you might think. If you are not sure what to do, that is perfectly normal. Here are three foolproof ways to allocate your 401k account, and a fourth way that might work if the first three options are not available.
1. Use Target Date Funds
The term "target date" means your targeted retirement date. You’ll know your 401k offers a target date fund when you see a calendar year in the name of the fund, such as T. Rowe Price Retirement 2020 Fund. Target-date funds make long-term investing easy. Choose the approximate year you wish to retire, then pick the fund with the date closest to your target retirement date. For example, if you're 55 in the year 2014, and plan to retire in ten years, choose a fund with 2024 in its name.
A target date funds spread your 401k money across many asset classes such as large company stocks, small-company stocks, bonds, emerging-markets stocks, real estate stocks, etc. It automatically chooses how much of which asset class to own.
Then, as you near the target date, the fund progressively becomes more conservative, owning less stocks and more bonds. The goal is to reduce the risk you are taking as you near the date where you will need to use your 401k money.
2. Put Your 401k Money In Balanced Funds
A balanced fund spreads money out across both stocks and bonds, usually in a proportion of about 60% stocks, 40% bonds. In times when the stock market is quickly rising, you can expect that a balanced fund will not rise as quickly. In times where the stock market is falling, expect that a balanced fund will not fall as far.
If you don’t know when you might retire, and you want a solid approach that is not too conservative and not too aggressive, choosing a fund that has “balanced” in its name will be a good choice. It evens out the ups and downs.
3. Use Model Portfolios - They Work
Many 401k providers offer model portfolios. A model portfolio is based on a mathematically constructed asset allocation approach. The portfolios have names such as Level I, II, III, or Conservative, Moderate, Moderately Aggressive. These portfolios are crafted by skilled investment advisors so that each model portfolio has the right mix of investments for its stated level of risk.
Most investors are best served by putting their 401k money in one of these models, rather than trying to pick and choose among available funds. Many of my friends send me their 401k statements and ask me what they should do. Whenever I see model portfolios available, I recommend they use them. It results in a better, more balanced, more disciplined approach than most people can accomplish on their own.
4. Spread 401k Money Equally Across Available Options
Most 401k plans offer some version of the choices described above. If they don’t, a fourth way to allocate the money is to spread it out equally across all available choices; this will often result in a well balanced portfolio.
For example, if your 401k offers ten choices, put 10% of your money in each.
Or pick one fund from each category; such as one fund from large cap, one from small cap, one from bonds, one from international, and one that is a money market or stable value fund. In this scenario you’d put 20%, or 1/5th of your 401k money in each fund.