How Do I Pick 401(k) Mutual Funds?

Most people experience the stock market and investing through mutual funds in their 401(k) at work. When trying to make your picks, you stare like a deer in the headlights at the daunting menu of 10-40 fund choices. You are not alone in your feeling of hopelessness. There is definitely a lot of investors that are clueless when it comes to putting together a diversified portfolio of funds through the plan’s menu. More often than not, employees just ogle at the performance numbers and pick a couple of funds that have done well.

So it’s no suprise when I frequently get asked how to pick funds in a 401(k). I’m going to show you how to do this without just eying performance numbers like the desert menu at your favorite restaurant. Here are some factors to consider:

Did the fund beat its benchmark?  Mutual funds are normally placed in asset class categories like large-cap, small cap or international. When comparing funds you want to know if the fund has been in the top 50% of funds. If not, you may want to pass. Look at the funds 3, 5 and 10 year numbers. That way you know how well the fund weathered during a complete market cycle. You can do comparisons on popular websites such as Google Finance, Yahoo Finance and Morningstar.

What’s the expense ratio? Whenever you are selecting funds, think like a cheapskate. When all things considered are the same, pick the fund with the lower expense ratio. That’s not to say a fund with higher expenses is not worth considering, but the returns should justify the added cost. An expense ratio with 1% can really have an impact on your returns if they are only 3-4%. You can find these ratios on your employers 401(k) website or visit the websites mentioned previously.

How long has the manager ran the fund? Most investors don’t even think about manager tenure when selecting funds. Did this manager just arrive at the fund, or is he responsible for the funds performance, good or bad? You also have to take into consideration how much experience the manager actually has. I’ll give you a real world example. Do you want a brain surgeon with 20 or more years of experience, or do you want the guy that just finished residency? So look at the number of years they have been managing portfolios.

How does the fund fit into my overall asset allocation? Asset allocation is probably the most important factor in this list. Many investors think they are getting diversified portfolio when they select a several funds, only to find out that those funds overlap or are in the same category. Not every asset class fits in your portfolio. For example, if you are a younger 401(k) investor, you many not need treasury bonds in your mix. So think about where you are in your retirement journey, and consider your outside investments as well.

This may not be an exhaustive list, but it is a good place to start. Retirement planning and portfolio construction is complicated and you only have one shot to save for your future. This is one time where the do-it-yourself investor should get help from a wealth advisor. If you have any further questions or would like a consultation, feel free to call me at (859) 225-2596, or email me at david@lexwealth.com.