So far, all of this 401(k) decision-making has been pretty easy. Now it is time for the fun part -- deciding exactly how and where you want to invest your hard-earned dollars.
Your typical 401(k) plan may offer 20 or more investment choices, including:
What are the differences? How should you split up your dollars to get the most bang? Most likely, your plan administrator won't be advising you on exactly where to invest. It's too much of a liability. First, let's go over what all of the options listed above actually are.
Money-market accounts and stable value accounts usually consist of certificates of deposit and U.S. Treasury securities. They are very secure, and offer small but steady growth.
Bond mutual funds are pooled amounts of money invested in bonds. Bonds are basically IOUs that companies or governments issue. Bonds are paid back with interest that is usually a fixed percentage of the amount purchased. When a bond within the mutual fund reaches maturity, the proceeds are used to purchase different bonds for the portfolio.
Stock mutual funds are portfolios of company stocks. When you buy stocks, you are buying a small part of the company. Stock mutual funds, like bond mutual funds, are managed by a professional money manager. Each company's stock within the portfolio has a different value that will fluctuate based on the company's business success. The mutual fund's share price is determined by its net asset value, which also fluctuates with the circumstances of the companies within the fund.
The first important decision you have to make is what kind of risk you are willing to take. You can take the conservative route, which will mean lower returns but a lower chance of losses. Or, you can take a moderate route, which includes a mix of risky and conservative options and moderate-to-low returns. Or, you can be aggressive and go for options with high earning potential but also higher risks. As a fund's potential return increases, its level of risk increases. Risk is essentially the fluctuations that will be a part of any fund's existence. This means that the time frame in which you have to invest will greatly affect the plan of attack you decide on for your 401(k) investments.
For example, if you are going to need the money sooner than later, then your risk tolerance will be lower and you'll need to choose low-risk investments with a more consistent and stable history of returns. You can also lower your risk by diversifying your investments.
If you have many years of investing ahead of you (10 or more), then you can probably afford to take more risks. The longer you have your money invested, the longer you will have to recover from any losses.
Your own personal feelings toward investing are also a big factor. Stressing over investments is not good for anyone. Think about what risk you are comfortable with and then plan your investments accordingly. Remember that most plans let you rearrange or "rebalance" your funds at least quarterly, and in some cases you can rebalance as often as you want.