3 Ways to Make the Most of Your 401(k)

3 Ways to Make the Most of Your 401(k)

By Anna Wroblewska

Congratulations! Now that you've opened a 401(k) account with your employer and started your contributions, you've taken an important step in retirement planning. Now how can you ensure that you'll get the most from it?

  1. 1. Make a diversified investment plan

    Lack of diversification is a major source of poor investment performance. Whether your portfolio is concentrated in company stock or in your favorite index, you'd almost alway better off over the long run by diversifying.

    To start, decide on your stocks vs. bonds allocation and build from there. For this decision, the key question to ask is what level of risk you can handle. If you're relatively young you might want to consider tilting your portfolio mostly towards equities, which have higher long-run returns. However, if allocating 80% of your portfolio to stocks is also going to keep you up at night, it might not be worth it. Your mental health is important, after all.

    Once you pick a big-picture allocation, it's time to diversify. The key is to get exposure to several different asset classes as cheaply as possibly. This can take the form of a mix of index funds covering large and small domestic stocks, corporate bonds of varying risks, and international stocks. You could also consider a target-date fund, which allocates to different mutual funds for you based on your age, or a lifestyle fund, which invests based on your risk tolerance.

    Pick the strategy that you're most likely to stick with: if you want a "set it and forget it" structure, you might be better off with the packaged fund. Just remember to do your homework by checking out the actual allocation percentages and the fees.

  2. Consider low-cost index funds

    High fees can cause serious damage to your returns over time, so you'll want to be extremely fee conscious. If you're looking at putting together a portfolio of mutual funds, consider investing in low-cost index funds instead (in the case of target-date or lifestyle funds, search for options that are built from index funds instead of actively-managed ones).

    Active managers might boast better performance at times, but that performance -- and the question of whether it's going to last -- is both costly and very difficult to predict. With index funds, on the other hand, you can enjoy the performance that they enjoy because you're not using up a large chunk of your returns to pay the managers.

    One analysis found that the Vanguard Total Stock Market index fund outperformed its actively managed competitors about 77% of the time. Based on the expected performance of all actively managed funds, the author concluded that a "winner" would need to outperform the Vanguard fund by nearly 5.5% to make up for the poor-performance risk that comes with active management. Currently, the median winner only outperforms the Vanguard fund by about 1%.

    Again, the root of the problem is high fees -- and the fact that it's very difficult to consistently beat the market, even if you're a professional money manager. Put the two together, and you have a very strong case for passive investment management.

  3. Stick with the plan

    Finally, be disciplined and stick with your plan. That means avoiding the extra fees that come from trading in and out of different funds or buying and selling the hottest stock. While each trade might not seem so costly by itself, they really add up over time and erode your returns.

If you have a well-diversified portfolio, all you need to do is rebalance every now and again. Advice differs on how often you should do it, but remember above all that the point is to eliminate costs. One way might be to check your portfolio once a year and rebalance only if it's way off your target allocation -- say 5% or 10%. Pick a number depending on your risk tolerance: if you get worried when your portfolio has too much equity, your margin of error might be lower.

For investors using target-date or lifestyle funds, you don't need to worry about rebalancing at all, as fund managers do it for you.

Practicing this kind of discipline can be very challenging, and it's admittedly a rather boring approach to being an investor. But it works because it minimizes costs and lets you enjoy a long-term perspective. So let the market do what it does, and take advantage of the opportunity to think about other things -- like remembering to raise your deferral rate when you get your next raise!