How to Choose the Best Funds for Your 401(k)

By Mike Lewis

NEW YORK (Money Crashers) — Unless you are self-employed, the investment choices for your 401(k) are established by your employer. While you have at least three options, the average plan offers eight to 12 investment alternatives, including the default investment if you fail to make a choice, according to the Financial Industry Regulatory Authority.

Debbie DeMatteo, chief investment officer for investment adviser 10-15 Associates, claims that 40% of plans even offer brokerage accounts, which means you can choose from a full range of stocks, bonds and managed and unmanaged funds, as well as other types of investments. This plethora of choices can be a problem when determining which path is best to achieve your retirement goals.

Your fund management philosophy

Benjamin Graham, Warren Buffett's mentor, believed there are two kinds of investors:

  • Active or "enterprising" investors. These people are willing to invest the time and effort to understand the complexities of various investments and keep current on the economy and events affecting those investments.
  • Passive or "defensive" investors. Such investors lack the time or inclination to make a substantial personal commitment to managing their investments and are willing to accept an average market return or pay someone else to manage their funds.

Graham, who has been called the "father of investment analysis" and the "Einstein of money," detailed his philosophy and methods in two classic books, Security Analysis written in 1934 and The Intelligent Investor in 1949. His three principles of investing remain valid for anyone seeking to maximize their investment returns.

  • Invest with a margin of safety. Graham believed that minimizing downside risk was just as important as seeking high-return opportunities. He advocated keeping a portion of each portfolio (25% to 75%) in fixed-income securities, depending upon prevailing market conditions.
  • Expect volatility and profit from it. The price of investments reflects human emotions, not necessarily the true economic value of the underlying asset. Graham advocated diversification to reduce portfolio risk as well as regular periodic investment as a method to resist emotional pressures or group-think to buy or sell securities.
  • Know what kind of investor you are. Are you an active or passive investor? Do you spend time daily keeping up with your investments? Weekly? Monthly? Do you do your own research or rely upon others? Do you listen to contrary opinions or go with the herd? Understanding your own capabilities, limitations and risk tolerance can help you decide on the investment strategy that is best for you.

Graham also pointed out that while speculation (buying an asset in anticipation that someone is going to pay more for it later) and investment (buying a piece of a business and letting it grow) are different investment philosophies, being successful in either approach requires considerable expertise and experience. In other words, passive investors are unlikely to beat the market's average return as either a speculator or investor.