How 401 k Plans Work

Making Your Selections

Of the choices you have, the riskiest, but also the option with the most earning potential, are stock mutual funds. Historically, stocks as a whole have had average annual returns of close to 11 percent. The tricky part is to select the right stock mutual funds. How do you know which are the best performing funds? According to an article by the Motley Fool, "Over time, the absolute best performing type of stock mutual funds, bar none" is an index fund. An index fund essentially matches the market. It has no manager and is simply made up of representative amounts of each stock in the index. It is the safest bet on achieving a steady rate of return that can come very close to or match that 11-percent average.

There are several index funds. The most well-known is probably the S&P 500 index. This index fund performs well, but there are also others that perform well -- such as the Wilshire 5000. Because it is very difficult to pick stocks individually that outperform an index like the S&P 500, it makes a lot of sense to invest in an index fund. The same article by the Motley Fool states that index funds outperform between 80 percent and 90 percent of actively managed equity funds.

The problem comes in when your 401(k) plan does not offer an index fund. What do you do then? Part of the boost in an index fund's value comes from the fact that is not actively managed, and therefore doesn't have the fee associated with that management. You can put together some funds that might act like an index fund, but it will take some work. The first things you have to look at are the fees and commissions that are charged. Look for a fund that has management fees less than 0.75 percent, no sales charges, and no 12b-1 fees. (12b-1 fees are annual fees that the fund uses for its marketing efforts.) You also want to look for a fund that has low turnover of stocks -- that typically means that it performs well. The fund's past performance is also a good indicator of future success, but is not a guarantee.