Trying to decide which mutual funds to choose for your 401(k) can be a nerve-racking endeavor.
But it doesn’t have to be.
To make retirement planning easier for you, here are five types of funds that can help you achieve strong investment returns while also prudently managing risk.
Large-cap stocks
Large-cap U.S. stocks should constitute the core of your retirement portfolio. These are some of the biggest and most successful businesses in the world, having earned market capitalizations of $10 billion or more. Large-cap U.S. stocks have a proven history of delivering strong long-term returns to investors, on the order of 8% to 10% per year on average. One of the best ways to get exposure to this asset class is through an S&P 500 index fund, which provides access to 500 of the largest publicly traded companies in America.
Excellent options for S&P 500 funds include Vanguard 500 Index Fund Admiral Shares (NASDAQMUTFUND: VFIAX), Schwab S&P 500 Index (NASDAQMUTFUND: SWPPX), and Fidelity Spartan 500 Index (NASDAQMUTFUND: FUSEX). These funds come with annual expense ratios ranging from just 0.04% to 0.09% — an important consideration when investing in mutual funds. All else being equal, the less you pay in fees, the more wealth you’ll build.
Small-cap stocks
Smaller companies have historically produced even higher returns than larger companies. That’s because these businesses can often grow their revenue and profits at faster rates than their larger brethren.
Small-cap stocks — which generally are considered to be those with market caps of less than $2 billion — are typically higher-risk than large caps. They also tend to be more volatile, meaning their prices fluctuate to a greater degree. But you can offset this risk and volatility by owning the other funds on this list, which together will help to adequately diversify your portfolio.
Good choices include Fidelity Small Cap Index Fund (NASDAQMUTFUND: FSSNX), Vanguard S&P Small-Cap 600 Index Fund (NASDAQMUTFUND: VSMSX), and Schwab Small Cap Index Fund (NASDAQMUTFUND: SWSSX), all of which have annual fees of less than 0.10%.
Mid-cap stocks
Mid-cap companies have market capitalizations between those of small caps and large caps (between $2 billion and $10 billion). Mid-cap stocks tend to be more proven businesses than small caps, but with larger growth opportunities than large caps. Thus, they can add another potential source of strong returns while also further diversifying your portfolio.
The Vanguard Mid-Cap Index Fund (NASDAQMUTFUND: VMCIX) and Fidelity Mid Cap Index Fund (NASDAQMUTFUND: FSTPX) are two solid funds in this asset class, and both have expense ratios of about 0.04%.
Emerging-markets fund
International stock funds can help to add another important layer of diversification to your investment portfolio. These funds are often classified as either developed-market funds or emerging-market (aka developing-market) funds.
Of the two, I would choose an emerging-market stock fund. Emerging markets tend to grow more rapidly than developed markets and can therefore produce stronger returns. In fact, China, India, and other developing markets are expected to generate a sizable portion of global economic growth in the decades ahead.
The Fidelity Emerging Markets Index Fund (NASDAQMUTFUND: FPADX) is a strong option here, with what looks to be one of the lowest — if not the lowest — expense ratio among emerging-market funds at 0.09%.
Short-term bonds
Lastly, some — but not all — investors may also want to include a bond fund in their 401(k).
I’m of the belief that investors with more than a decade until retirement don’t need to invest in a bond fund. Bonds and other fixed-income funds typically generate far lower long-term returns than stock funds. Stocks may outperform to an even greater degree if interest rates rise in the coming years, as many market watchers expect. When interest rates rise, the prices of existing bonds — and therefore bond funds — fall.
Additionally, while bond funds tend to be less volatile than stock funds, younger investors don’t need that benefit, because they can simply ride out market downturns. In fact, market sell-offs can be beneficial to stock investors, as you can buy more shares when prices are low.
Even those who are closer to retirement may not need to purchase a bond fund if they have cash reserves outside of their 401(k)s that they can use to fund their first few years of retirement. This allows you to keep your 401(k) assets in stocks, which will likely generate higher long-term returns and thus provide you with substantially more money later in retirement.
However, if your 401(k) holds the vast majority of your retirement assets, and you’re near or in retirement, then a bond fund could make sense. In this case, I would use a short-term bond fund, as bonds with shorter maturities are less exposed to interest rate risk than those with longer-term maturities. You’ll earn a lower yield, but you’ll protect yourself from the possibility of sizable losses (as is possible with longer-term bond funds) if interest rates rise in the years ahead.
The Vanguard Short-Term Index Fund (NASDAQMUTFUND: VBISX), with its 0.15% annual expense fee, is a solid choice in this regard.
Putting it all together
Owning a portfolio composed of large-, mid-, and small-cap stocks will allow you to profit from the growth of nearly the entire U.S. economy. Adding an emerging-market stock fund will help to further diversify your portfolio and add another strong growth element fueled by rapidly expanding international economies. Finally, a short-term bond fund — if it fits your personal situation — can help to protect and preserve the money you’ll need in the near term. Together, these mutual funds can form the core — or even the entirety — of a well-diversified 401(k) investment portfolio.
