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How To Choose Investments in Your 401(k) Plan

written by: Brian Nelson•edited by: Rebecca Scudder•updated: 7/7/2011

Choosing investments inside of your 401(k) plan can be nerve racking. You are going to depend on the money for retirement, so you need to make good choices. Here is how.

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    Choosing Good 401(k) Investment Options

    Deciding how to choose good investment options for your 401(k) plan can be a difficult task. Many plans offer dozens of choices, all of which have good sounding names.

    Unfortunately, those names can be misleading. However, with a bit of research and a sharp eye, you can make smart investments inside your 401(k)

    The first step is to determine exactly what the investment options actually are. Many options will be clones of retail investment mutual funds. The ones that have the exact same name as a mutual fund you can buy directly through your broker are managed by the same company and fund manger as the retail mutual fund. Thus, you can use research from your brokerage or Morningstar for those funds.

    However, keep in mind that the share class may be different which means that the fund expenses and returns will be different, so while investment research and recommendations are valid, the numbers stated for the returns of the retail fund is not.

    For funds that do not have a direct correlation to a retail fund, getting good research can be tougher. There are generally two cases of this.

    The first are proprietary funds. That is mutual funds that have no outside counterparts and whose fund managers do not manage any money in the retail world either. Typically, these funds can only be purchased in products sold by the fund or the fund’s parent company. If the company that runs the 401(k) plan (the trustee, not your company) has the same name as the mutual funds, they are likely proprietary. This is most often the case with banks and insurance companies. These funds are almost always best avoided if there are other options, so cross them off your list.

    The second type of investment choice with no retail fund twin are investments which are run by the managers of regular retail mutual funds under the brand name of another company. These funds are known as sub-advised funds and are often marked as such on your 401(k) materials. In this case, research the name of the fund manager and find the regular mutual fund they manage and do your research on that fund. While the two investments will not be exact, it will give you a better guide than relying soley on the sub-advised fund information.

    If the above don’t generate enough usable investment options, then you will have to dive into the prospectus or other materials provided for each investment option. The key to this analysis is to ignore all multi-year averages such as the 3-year average, 5-year average, and 10-year average. The reason is that multi-year averages allow bad years to be covered up. A fund with a +50% year, then a -75% year, then a +100% year is a very volatile (and probably poorly run) investment. However, its 3-year average will be a much more benign looking +25% per year.

    Always look at each individual year of returns to get a feel for the fund’s past performance. Decide if you can stomach the worst year the fund has had. If not, pick a different option.