• You all walked into a meeting.
• An HR administrator handed you a folder chucked full of loose documents.
• You were released with little direction and told to bring the papers back all filled in.
Am I close?
It’s pretty sad that something so important to our livelihoods later on in life is treated as another routine task. There are many things that should be explained to you when you sign up for your 401k (click here for my complete guide on this topic).
But if there’s one thing where people REALLY need help, it’s deciding which mutual funds to pick for their plan. Past returns? Large cap / small cap? Expense ratios? What does all this stuff mean?
In the MyMoneyDesign household, we have both a 401k and 403b. So let me use what I’ve learned to help steer you towards making the best choices you can make.
First Things First – You’re Not a Fortune Teller:
One of the biggest mistakes people make when they’re picking their mutual funds is to look at the past returns and expect that the fund will do the same thing going forward. Unfortunately, that’s just not how it works.
People, say it with me:
• Past returns do not guarantee future returns.
It’s impossible to know if you’re picking a “true” winner because NO ONE knows what will happen in the future! If we did, then we’d be a whole lot richer than we are now! The fact that an investment could go up or down is the chance you take with an investment.
With that said, when picking your mutual funds, there’s really only two things we can do:
• Avoid funds that have already proven to be losers
• Maximize returns by keeping our costs down as much as possible
Keeping these two points in mind, here are five questions you need to ask yourself to pick the best funds:
1) Does this fund do better than the S&P 500 return over the long run?
The S&P 500 has returned an average annual rate of 8% for over half a century. Is the fund you’re looking at making that much?
How do you find this out? Look at the Past Returns data in the 10 year return or Since Inception columns (if the fund is more than 10 years old). The older the data, the better. This is because 10 years or more is enough time to capture the ups and downs of a significant period in economic history, and demonstrate how the fund performed or defended against the trend.
What about 1, 3, or 5 year return data? You can pretty much ignore this. Short-term data basically trails the ups and downs of the market. Unfortunately, this is just not enough time to determine if the fund is stable enough to beat the trend.
Remember – this doesn’t mean the fund you pick is automatically going to do 8% or better. It can indicate the integrity or stability of the fund against the rollercoaster of the market.
Advanced Tip – If you’re already aware that other benchmarks exist (like ones for bonds, mid / small cap funds, foreign funds, etc), then you can use a more targeted benchmark to compare against the performance of your choices. To do so would be more of an apples-to-apples comparison.
2) How much am I paying for this mutual fund?
Every mutual fund option you choose will have a fee called an “expense ratio”. Your goal is try to pick the ones with the lowest fees possible.
Overlooking the expense ratio fee is another big mistake when picking your 401k funds. A fund with too high of fees can have significant implications on your returns. Here’s an example:
Ouch! Not only is that $1,890 in fees if you have a $100,000 portfolio, but let’s say the fund only returned 3.06% (as in the example up top). That means you’re really only making 3.06 – 1.89 = 1.17% per year, or -1.83% if you count a 3.00% inflation rate. Terrible!
What’s a “normal” expense ratio? Well, consider a passively managed index fund such as the “Vanguard 500 Index Fund Investor Shares (VFINX)” has an expense ratio of 0.17%. For that same $100,000 portfolio, that’s only $170 per year in fees. How’s your choice comparing?
As a rule of thumb, anything over a 1.00% expense ratio is probably more expensive than it needs to be.
3) What does Morningstar think of this fund?
Have you ever heard of “Morningstar”? Morningstar is a service that ranks mutual funds on a five-star system (i.e. the more stars the better). Although a Morningstar rank is not a perfect sign of an all-star pick or great returns to come, it does hold some weight. They use far more criteria to judge mutual funds than you and I would ever consider. Here’s an example:
If nothing more than a second opinion, use the Morningstar ranking as an aide to picking your winning funds. If the ranking wasn’t given in the information you received, you can go to Morningstar’s website and easily search the fund yourself.
4) How diversified do I want to be?
Not all funds invest in the same thing or the same place. And to some degree, you can use this to your advantage.
Without getting too technical, you can pick some funds that are more aggressive at returns (and riskier) than others. For example:
• Risk increases as you go from large to medium to small funds.
• Rick increases as you go from value to growth funds.
• Foreign funds are perceived as riskier than US stocks, and US stocks are usually more risky than bonds.
A big part of which ones to pick depends on how you feel about risk. If you’re willing to gamble, then put some (not ALL) of your money on the riskier choices. But if the thought of losing your money haunts you at night, then stick to the safer choices.
In the absence of all else, use the old rule of thumb:
• 110 – Your Age = The percentage of your portfolio that should consist of stocks. The rest should go into safer investments like bonds.
On the breakdown of stocks, try to spread at least a small amount of your money into the small/mid cap or foreign funds. I wouldn’t recommend exceeding a 20% allocation in any one of these categories.
5) How does this fund compare to other choices?
Everything is relative. Some employer plans offer anywhere from 10 to 100 mutual fund choices. Although your options may not rival the 8% benchmark or come close to the 0.17% expense ratio, you may just have to simply play the hand you’ve been dealt – Especially if you are trying to qualify for your employers 401k match.
Perhaps your 401k fund options aren’t perfect, but there will be some that are better choices than others. Remember – Use these tips to help make the best of the choices you have.
Readers: How do you choose funds for your 401k or employer retirement plan? What special criteria do you use? Beginners – Are there any other questions you have you have when you’re first making your choices?
Related Posts:
1) Help! I Just Got My 401k Packet At Work! What Do I Do?
3) A Strategy for Maxing Out Your Retirement Savings
Photo Credit: Microsoft Clip Art
Awesome post. This is a great extension of my post on how to invest a 401k plan. It drives me nuts that there is no education provided by the company when people get their 401k packet.
I totally agree! I would had loved it if someone explained it to me – and I REALLY mean explained it! I just clicked on your article. Nice work yourself! Total coincidence that we used the same Clip Art photo 🙂
I agree that one of the biggest mistakes people make is to assume that past performance equals future performance. This is a dangerous assumption. In fact, what I do is assume that if a fund has done extremely well in the recent past, that it will underperform in the near future.
I think the other big mistake people make when saving for retirement is to not save anything at all. Most times they don’t save because they’re overwhelmed by the choices and don’t know where to start, so they avoid it altogether.
You’re 100% right that they get overwhelmed. Returns? Expense ratios? Benchmarks? Holdings? I sometimes take for granted how many times I’ve looked at Vanguard or Fidelity to realize what a jumble-pile of information this must look like to a beginner.
Not saving at all is a suicide move!
I do not know much about markets so when it comes to choosing an appropriate mutual fund I rely on advice of others. I recently bought a Mutual fund advised by my fried(Which as advised to him by his some other friend!)
I don’t analyse portfolio. I do not know much about future trends but I did checked how it performed in past 20 years. It did better than other MFs in market. But now it is not doing that good, it is just performing average.
One of the good suggestions I recieved from my friend was to invest same amount of money in the MF every month rather than investing once in an year. This helps to average out the losses.
Karunesh – The last thing you mentioned is a good point! That strategy your friend told you about is called “Dollar Cost Averaging”. And yes, it can be a powerful hedge against losses. I wrote a different article a few weeks back about how Dollar Cost Averaging would have helped you during the Lost Decade that you may find interesting:
https://www.mymoneydesign.com/personal-finance-2/retirement/would-dollar-cost-averaging-have-saved-you-from-the-lost-decade/
I was helping my sister set up her portfolio last week and that biggest thing I kept stressing was that the future is not guaranteed to be the same as the past. The markets aren’t the same. Its hard for novices (including myself) to understand that sometimes.
I STILL have to remind myself to ignore the returns! I think our brains just really want some validation that the funds we’re picking are going to be great ones, so we rationalize that what happened last year will happen again. It’s very abstract to grasp that no one really knows what’s going to happen in the markets.
It does me bad to admit that I’m one of those people who tackled his mutual fund investing the same way I eat a sandwich. No thought involved, no research, and very little consideration regarding the market.
There’s a lot of homework that you have to do in picking the best mutual funds for your portfolio, and a lot of folks either aren’t educated enough, or just don’t want to take the time to first do the due diligence.
Unfortunately, I put about as much time into my selections as it takes you to read this article. I think above and beyond filtering out the past losers and expensive funds, there is really very little else you can do. Most funds own too many holdings for common people like you or I to really grasp what the mutual fund will do. AND there is also the fact that no one knows what the market will do tomorrow.
This was really an awesome and informative post!!! I wish I had this when selecting my funds. I actually went with a target retirement fund so I wouldn’t have to figure out every detail but for my roth IRA I blindly selected some funds. I’ll have to look at the info again and see what I did right or wrong, and fix accordingly.
Welcome to the site and thank you for the compliment! Target date funds have received both great praise and harsh criticism. I love the concept behind them – set it and forget it! But the ones in my employer’s 401k plan also happen to be THE MOST EXPENSIVE at an expense ratio of almost 2%. OUCH – that’s $2,000 for every $100K I’ve got. No thanks. I’ll pick my own funds.
But that doesn’t mean that good and cheap ones don’t exist. I hope yours is doing well!
Fees can be such a huge drain on returns. Just one or two percentage points difference can make a massive impact over the long run. Doing the math, and assessing the present value of future cash flows, it can be quite noticable. This is why I like index funds!
You’re right – fees are a killer! I think every time I’ve changed my portfolio around, I keep reallocating more money to my cheap index funds because 1) I realize that I’m probably not going to do much better than the index and 2) why not save the money!
I’m loving these posts. As I know pretty close to nothing about selecting funds or opening accounts. Your posts on investing have been the most helpful and easiest for me to understand.
Goal accomplished! Hearing feedback like this is very encouraging. I appreciate the compliment! Are there any other topics you want to know more about?
Great article. I am using this formula, 100 – your = % you invest in the bonds or the index funds. So, as you grow older, more money will flow into safer instruments.
I like that revision to the equation! Most people think that investing in “safer” investments is because they’re afraid. Personally, I think that minimizing your risk is probably one of the best investment tools you’ve got. If anything, I’m not “afraid” to simply save more money each month and allocate it to safer funds to achieve the same goal as someone who is using a riskier strategy to do the same.
Nice piece. I’d only add that when comparing expense ratios, remember to compare apples to apples. International funds will nearly always be more expensive than domestic funds, so only compare “like” funds when looking at fees.
Good point! Once you realize there is more than just the S&P 500, try to follow the appropriate benchmark. And those International funds are a little pricy. But unfortunately the world is bigger than just the U.S.
Once I read the article i expected to see much more trackbacks than it has now. Well done. Honestly I admit i didn’t put much attention in my choice for 401(k) fund. I have 80% stock portfolio, 50% in 2040 target fund, where as rest is divided between 2035 and 2045 target funds. I never pad attention to individual components of those target funds.
Thanks! That really means a lot to hear. Although the site is starting to gain more traffic, it still has a long way to go in terms of getting noticed.
There’s nothing wrong with your choices so long as they’re not the most expensive funds available and you’re happy with their performance. I avoided Target Date Funds in mine because they were too costly and had one of the lowest returns.