In the Learn to Invest course, we recommend investing in a simple, diversified 3-fund portfolio made up of index funds. We recommend investing in a Total Stock Market Fund, and Total Bond Market Fund, and an International Stock Fund according to the Bogleheads invement philosophy.
This is easy to do when you have full control over your investment selections in, say, an IRA or your regular brokerage account. But we don't always have full control. In your 401(k), the options available for investment are typically selected by the employer or the plan administrator. You basically get a menu of options, and you need to figure out what are the best investments for you!
Because every company offers a different menu, it's up to you to decide what are the best options to choose. You'll need to do your best to approximate the 3-fund portfolio.
Here's a step-by-step guideline to approximating the Total Stock Market and the 3-fund portfolio in your 401(k):
1. First, identify which funds are index funds. Eliminate all actively managed funds, and focus on low-cost funds. Sometimes the word "Index" will be in the fund name, but sometimes not. Other times there might be a category that determines which type of fund it is (e.g. mutual, index, large cap, small cap, etc). Because each bank's platform looks different, the best way to identify index funds is to look at the expense ratio. They should range from 0.01% to 0.2%. The lower the better. This should eliminate the vast majority of 401k funds that are provided to you.
2. Second, identify which funds are broad-based. Look for words like “Total Stock” or “Total Bond” or “Aggregate Bond” first. Remember we want funds that ideally represent the Total Market.
3. Lastly, pick your allocations. Choose between stocks and bonds.
Given the three themes above, we've provided you with a set of "routes", or options. Go through each, starting with Option A and see which route is readily available to you. Then you can access which is ultimately the best solution for your 401(k) fund selection.
Option A: Broad-based, low-cost index funds are readily available (your best option)
Option B: Broad-based stock index fund isn't available
Option C: Broad-based bond index fund isn't available
Option D: Target-Date Retirement Fund is available
Option E: Only active mutual funds are available
Option A: Broad-based, low-cost index funds are readily available (your best option)
In an ideal world, your company offers you the following types of funds:
A broad-based US stock fund
A broad-based US bond fund
A broad-based international stock fund
If these types of funds are offered, then you can easily create the 3-fund portfolio, but just with a separate set of index funds.Below are some Total Market Index Fund examples you might find in your 401k plan:
US broad-based stocks
Vanguard Total Stock Market Index Fund Admiral Shares - VTSAX (0.04% expense ratio)
Schwab Total Stock Market Index Fund - SWTSX (0.03%)
Fidelity Total Market Index Fund - FSKAX (0.015%)
iShares Core S&P Total U.S. Stock Market ETF - ITOT (0.03%)
International broad-based stocks
Vanguard FTSE All-World ex-US Index Fund - VEU (0.06%)
Schwab Emerging Markets Equity ETF - SCHE (0.11%)
US broad-based funds
Vanguard Total Bond Market Index Fund - BND (0.05%)
Schwab U.S. Aggregate Bond Index Fund - SWAGX (0.04%)
Option B: A broad-based stock index fund isn't available
You have two options if a total stock market option isn’t available:
1. Choose simplest option (if it's available to you)
Invest in an S&P 500 index fund. This fund tracks the largest 500 companies in the US. In a retirement plan with limited choices you might very well opt for an S&P 500 index fund to serve as the US stock component of your allocations. Costs will remain low and you’ll still capture the largest component of the total stock market.
S&P 500 Index fund examples:
Vanguard 500 Index Fund Investor Shares - VFINX (0.04%)
Fidelity 500 Index Fund - FXAIX (0.015%)
Schwab® S&P 500 Index Fund - SWPPX (0.02%)
Sometimes you might see a 1000 Index, or a 3000 Index... this tracks the largest 1000 and 3000 companies respectively and are great options too.
2. Alternatively, you can approximate a Total Stock Market fund by combining a large-cap fund (like the S&P 500), with a ‘mid-cap’ and a ‘small-cap' fund (if they are available to you)
Market capitalization is a fancy way of saying how big a company is. Big companies are perceived to be less risky than small companies. But to truly invest in the entire stock market, you’d want all company sizes, not just the big ones. The words "large", “mid” and “small” are usually in the fund names or descriptions. You will only wanna take this approach if the expense ratios remain low for the small and mid-cap funds. If you are taking this approach a fund breakdown might be as follows:
3-Fund Strategy: | Further Breakdown: | ||
|---|---|---|---|
US Stocks | 50% | Large Cap | 40% |
Mid Cap | 5% | ||
Small Cap | 5% | ||
International Stocks | 30% | ||
Bonds | 20% |
Fund examples using market caps:
Combine a large cap (e.g. Vanguard 500 Index Fund Investor Shares - VFINX, 0.04%)
With a mid-cap fund (e.g. Vanguard Mid-Cap Index Fund - VIMAX, 0.05%)
With a small-cap fund (e.g. Vanguard Small-Cap Index Fund - VSMAX, 0.05%)
Option C: If a broad-based bond index fund isn't available
Approximating the total bond market is not as easy as the total stock market. To truly approximate a total bond index fund, you'd need to:
Invest across bonds with short, intermediate, and long-term maturities. Maturity is a fancy way of saying how long the bond lasts for (say, 1 to 30 years). The longer the timeline, generally speaking, the more risky the investment.
And, invest across bond types - namely treasury (big government), municipal (states and local governments), and corporate (companies). There are more still.
To keep things simple, we recommend investing in an intermediate municipal or federal bond fund. Intermediate municipal or federal bond fund examples:
Vanguard's Intermediate-Term Index Fund - VBIIX (0.07%)
Vanguard Intermediate-Term Treasury ETF - VGIT (0.04%)
Fidelity® Intermediate Treasury Bond Index Fund - FUAMX (0.03%)
iShares National Muni Bond ETF - MUB (0.07%)
To learn more about bonds, you can read here.
Option D: Invest in a Target-Date Retirement Fund
You can simply invest in a Target-Date Retirement fund (as presented to you in the Target-Date Retirement funds section earlier in this course). This is all you need to invest in as it will cover both stocks and bonds. Just watch out for high-expense ratios with target-date funds.
Option E: Only active mutual funds are available
Some people will comb their 401(k) plans and find that there are no index funds available to them. The question then arises "well, should I invest in costly mutual funds?" The answer is almost always yes. The tax benefits that you get from contributing and investing in your 401(k) are SO GREAT that it outweighs any fees that are eaten away from expense ratios. You may face, say, a 0.9% expense ratio, but you will ultimately save 15% on long-term capital gain taxes. Not to mention, your next job might offer a great 401(k) plan, in which case once you make the move, you can rollover your old 401k portfolio into your new one.
Bonus Idea!
Not happy with your retirement fund options? You aren’t alone. Here is a fun article that includes a draft email you can send to your HR or benefits department asking for better fund options. There are many examples where employees have banded together to ask for better options and change has happened! This includes those who want to fight for more 🌎 ESG funds 🌎 within their retirement portfolios.
Disclaimer:
The information contained in the Yield & Spread website, course materials and all other related content is provided for informational and educational purposes only. It is not intended to substitute for obtaining accounting, tax, or financial advice, and may not be suitable for every individual. Yield & Spread is not a registered investment, legal or tax advisor or a broker/dealer.