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We’ve talked before about how much American workers love their 401(k)s. The tax deferral, the ease of saving with each paycheck and the employer match are huge pluses for anyone who’s serious about saving for retirement.
While we love these features—and the majority of workers take full advantage of them—we’re less infatuated with the more technical aspects of our workplace retirement plans. A recent study of 401(k) investors shows that nearly half feel they don’t know what their best investment options are, and a third are stressed out about correctly allocating their 401(k) dollars.
Those concerns are no joke. Proper diversification plays a huge role in your ability to meet your retirement savings goals. Diversification isn’t complicated. It simply means you’re spreading your money among several types of investments to help reduce your risk and take advantage of the full power of the stock market to build your retirement savings.
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Investing in mutual funds is the first step to diversifying your retirement investments. Mutual funds invest in dozens, even hundreds of companies, so you’re not betting your entire retirement on one company’s performance like you would by investing in single stocks.
But to achieve a well-diversified 401(k), you’ll want to invest in several types of mutual funds that are designed to perform well in different market conditions. Dave recommends you invest equally in four types:
- Growth funds invest in established, less risky companies. They have the potential for strong returns without following volatile market swings.
- Growth and income funds focus on big-name companies, providing stability in shaky markets and steady growth when then market rebounds.
- Aggressive growth funds are somewhat riskier, but they give your portfolio a kick by investing in smaller companies with big growth potential.
- International funds allow you to invest in household brands that aren’t based in the U.S.
Diversification In Action
This mix of mutual fund types will work together as a team to lower your risk in down markets without sacrificing growth in strong market cycles. You can see how that works with a simple example:
Investor Joe doesn’t know much about investing, but he wants to get started as soon as possible. He selects one fund—the one with the highest lifetime average annual return—as his only 401(k) investment option. Joe doesn’t realize his fund is only a couple of years old, and it’s an aggressive international mutual fund—an extremely volatile category. At the slightest hint of global economic trouble, Joe’s mutual fund is walloped with an 8% loss in value—and it keeps dropping.
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Investor Jane, on the other hand, chose Dave’s recommended mix of funds for her 401(k). Like Joe, Jane’s international mutual fund took a beating and dropped several percentage points. Even her aggressive growth fund took a hit and delivered lower returns. But her growth and growth and income funds maintained steady performance and kept the overall performance of her 401(k) in positive territory.
Keep in mind that you can’t diversify away all your risk. Your mutual funds will rise and fall in response to the stock market. But as you can see from our example, even though Investor Jane perhaps didn’t have her best investing year, she certainly came out ahead of Investor Joe and his one “top-performing” fund.
Fund Selection Isn’t as Easy as It Sounds
While your mutual fund choices may be limited to just a handful of options in your current 401(k), you can open up any old 401(k)s you have to thousands of fund possibilities through a rollover to an IRA. With a rollover, you can fuel the growth of your nest egg with the best mutual funds in each of the fund types Dave recommends.
Rollovers can have tax implications if they’re not handled correctly—just one more reason to consult a professional before you begin the rollover process. If you don’t already work with an investment pro, find an investing professional in your area today!