Michael on August 20th, 2008
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You: Which funds should I pick?

What?

You: In my 401(k) account. . .I have like a dozen funds to choose from. Which ones should I pick?

I can’t give you specific investment advice.

You: Right. I knew that. Well, then, how can I pick the right funds?

There aren’t any “right” funds.

You: Okay, I think you’ve got this financial education blog all wrong. You’re supposed to be helpful.

I’m trying to be.

You: Excuse me for saying so, but I’m not quite seeing it yet today.

Fair point, but I’m just answering exactly the questions you’ve asked.

You: Where’s the issue then?

You said “right” funds. There’s no such thing. If there were, taken to its logical conclusion, there would be no “wrong” funds and then, paradoxically, there would be no funds that were especially “right.”

You: What is this, Waiting for Godot?

Love the 8th grade English reference. Classic. But unlike that play, we’re going to get somewhere today.

You: When, today?

Now.

You: Okay, good.

While there is no “right” fund, there are funds that are more likely to be “right for you.”

You: Why?

Because you have specific investment needs and a specific risk profile. In the case of a 401(k) plan, your specific investment need is (or, at least, should be) to provide for a comfortable retirement. If you’re more than, say, 20 years from retirement, you have a very long-term horizon for retirement.

You: Rubbing it in?

Not at all. Rather, I’m emphasizing that you ought to consider a long-term philosophy when you select your investments. Someone looking that far out (20 years) can afford the normal gyrations of the stock market and therefore should be invested primarily in stocks. For my best guess as to how you should invest your 401(k) account (by asset type, not fund type), visit my unbelievably simple asset allocation tool.

You: Unbelievably simple?

There’s only one question.

You: That’s true of some blue books.

True enough, but the one questions in this case is demographic in nature.

You: Oh.

Yeah.

You: I can do that.

Indeed you can. There are other asset allocation calculators out there which are more robust (google: asset allocators), but I prefer simplicity.

You: Okay, but how do I convert this asset allocation information into fund selections, especially if I don’t know how to pick the “right funds for me.”

Now that’s a good question.

You: Don’t tell me it’s my first one.

It’s definitely not. There was an excellent article a few days ago called “Five Ways to Pick Mutual-Fund Winners” which provides a great summary of what you should consider. Check it out. Not enough time?

You: Maybe.

Here are the top 5 methods, according to writer Jonathan Burton, along with my italicized comments.

1. Expenses – the lower your expenses, the easier the job the fund manager has to do to in order for you to end the year with more money.

2. Risk-adjusted return – Check out the fund’s volatility. In any one year, a manager can get a higher return (as well as a lower one the following year) by taking additional risk.

3. Results vs. peers - Classic apples and oranges analysis. Make sure your gala isn’t next to your naval.

You: That’s what she said.

Wow.

4. Portfolio Yield – Yield is the current rate of income (think dividends) divided by the value of the holdings. (think stock price). The point here is that yield can increase for two reasons: a) because income paid out by the underlying stocks has increased, or b) because the value of the stock holdings has decreased. Only one of those is a “good” reason, so you can’t get too excited about a higher portfolio yield.

5. Manager Tenure – When you’re looking at the records of funds over the last 3, 5, or 10 years, make sure that the current manager has been there at least that long. Otherwise, it’s like saying that Joe Girardi is a great manager because of all the World Series the Yankees have won.

You: Those happened before Girardi become the manager. He just started this year.

Exactly. Irrelevant. He may be a great manager, he might not be, but the evaluation period is mostly in front of him, not behind him.

# # #

What other factors do you consider when selecting a mutual fund from your 401(k) plan?

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3 Comments to “Making intelligent 401(k) investment decisions”

  1. Right on target. In this market, it’s been especially hard. I’ve lost quite a bit, being in the high risk funds. luckily they had done really well before the crash, so I’m only losing “on paper money” so far. With the tax break, and perhaps an employer’s match, it gives a little cushion.

    I stumbled

  2. Paul says:

    Hey, don’t feel so bad. Eveyone lost in the recent crash. It happens. There are few that can click the mouse and make the moves that are needed from time to time depending on which way the market is moving. I have made the same mistakes myself over the years. But, I have also been able to makes a couple of moves that I know have saved me lots of money over the long haul. I saw the signs of the crash last year. I was afraid to make a move as usual. But, something inside me said, ‘move most money into bond funds’. So, I did. The rest I watched and still watch gyrate up and down. But, the money I put into the bond fund sits comfortably and has actually made me money on the interest which was a delight after I noticed it. Now, the big concern is, when do I move back into equities. Hmmm. I’m hoping I can get back in without being the last player. I’m closer to retirement than I realize and I’d like to be able to live happily ever after with my earnings. We’ll see. All I can say is watch the financial market and the news. Don’t follow any one sage or analyst. Use your gut feeling, it knows best. Then, make a move and relax. I am.

  3. anil says:

    makes a couple of moves that I know have saved me lots of money over the long haul. I saw the signs of the crash last year. I was afraid to make a move as usual. But, something inside me said, ‘move most money into bond funds’. So, I did. The rest I watched and still watch gyrate up and down. But, the money I put into the bond fund sits comfortably and has actually made me money on the interest which was a delight after I noticed it. Now, the big concern is, when do I move back into equities

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