The 3 Fund Types You Need to Know About

Have you ever gotten excited to finally do the responsible thing and start saving in your 401(k) but got overwhelmed with picking the investments? These decisions can cost you hundreds of thousands of dollars over the course of your life, but the truth is that there are no perfect answers because no one knows what investments will do the best in the future. The key is to make educated guesses that give you the highest probability of success. That is why I want to give a basic primer on how to sort through types of funds in your 401(k).  If you have questions, like the reader who inspired this post, just let me know.

This Fidelity 401(k) PDF, submitted by one of my favorite readers, has 29 options, which is more than enough to discourage the indecisive among us. Fortunately, the PDF breaks the funds into 3 main categories which we can use to wrap our minds around it.

  • Stock Investments
  • Blended Fund Investments
  • Bond/Managed Income

Blended Fund Investments

Of the 29 options 13 are categorized as Blended Fund Investments and you will see that 12 of them have the same name except for a small change in each. The numbers in these funds stand for the year you plan to retire. Since, I am 26 and the standard retirement age is 65 I would likely want to pick the fund with the year closest to 2057. Since that exact year isn’t an option I would pick 2060. Just be realistic on when you expect to retire because picking 2020 won’t magically give you enough money to retire in 2020.

These funds are very user friendly because it is like turning on autopilot. When you are far away from retirement Fidelity will have more of your money invested aggressively but move it into more conservative investments as you get closer to needing the money. For example, right now the fund for 2060 has just 10% in bonds and 90% in equities/stocks – 10% conservative and 90% aggressive. If you are about to retire you typically don’t want to have 90% of your money in stocks which can drop 50% or more with relative ease. That is why the 2020 fund is much more conservative and only has about half the money in aggressive investments.

Target date funds are the easiest way for you to stay on track and are a one stop shop because they are actually bundles of many many investments.  For example, the 2060 fund in the PDF actually has 30 mutual funds inside it. This means by selecting just one target date fund you have made your life much easier and managed to diversify your investments like a pro.

One last not about this category, there is one more fund called “FIAM INX TD INCOME V.” As a general rule of thumb, if a fund says “Income” and doesn’t have the term “Growth” in the title too then it is very conservative. That means it is best for people who just want to protect their money and safely withdraw a few percent of the portfolio every year to spend. In other words, save those funds for the Silver Tsunami.

Bond/Managed Income

For the most part these funds have under performed the other fund categories and that is because bonds on the long term earn you less money than stocks. There are certainly times when it is better to own bonds, but since 1926 the annual growth rate of stocks has nearly doubled that of a typical bond portfolio. Just remember that stocks can easily drop more than double the rate of bonds in the short term, which is why when investing in stocks and other aggressive investments you want to have a time horizon of 10 years or more for that money. For most people the entire Bond/Managed Income category doesn’t have much to offer unless you are trying to do market timing in your 401(k) which is generally a bad idea. Let’s move on.

Stock Investments

The last category is subdivided into 4 sub-categories.

  • Large-Cap
  • Mid-Cap
  • Small-Cap
  • International

Cap is short for capitalization which is just Wall Street jargon for the sale price of a business. For example, people keep talking about how Apple’s market cap just hit $1 Trillion. That just means that if you wanted to be the sole owner of Apple you would have to spend at least $1 Trillion to buy it because there are 5 billion shares of Apple selling for about $200.

The dollar amounts for Large, Mid, and Small change overtime but each category tends to be roughly 10 times larger than the next. In general, the larger the capitalization the less risk there is to the company. It is pretty unlikely that that a $1 Trillion dollar company is going to be worthless overnight because they often have multiple income streams and are very well established. Small companies tend to have higher chances of going bankrupt, but they are still worth investing in because they tend to have a greater growth potential. The last category, International, is just what is sounds like. It holds companies that are based in countries other than the country in which the fund is being promoted. They can be very helpful at times when the economy in your own country is not doing as well as others.

Of the funds listed under the Stock Investments there are several I would probably disregard for now simply because they do not have 10 plus years of track record available. Also, the ones listed that don’t have 10 plus years of track record are actually commingled pools, which are not regulated like traditional mutual funds. Commingled pools have a number of benefits, but to be honest I am a bit undecided as to whether or not I would use one yet especially before they have 10 years of track record.

For most people I think target date funds are the best solution, but if someone is wanting to be a bit more aggressive they could higher an investment adviser to give one on one guidance or consider the Dave Ramsey and Warren Buffett approach of going all stocks. This could potentially earn more money over the long haul than the target date fund, but the portfolio will almost certainly go down much more sharply than the target date funds during market corrections. I

If you want to be aggressive you could essentially put 25% into each of the four stock categories. This is pretty much the same as what Dave Ramsey would recommend.  You could spread the 25% out among each fund available in the sub-categories or just pick one from each. The catch here is that down the road you will probably want to re-balance the portfolio. For example, after the first year International funds may do the best and grow to be 40% of your total portfolio. Well if that is the case you will probably want to get it back down to 25% by adding more money to the other funds. That is called re-balancing. You want to re-balance because things go in cycles and what does poorly over several years will likely do better over the next several years etc. Just remember if you use a target date fund you wouldn’t have to worry about that at all.

Sit on your Hands

With few exceptions, I recommend never switching investment strategies. I do encourage re-balancing your portfolio according to your original investment plan, but I strongly discourage switching investment strategies with already invested money just because you think you found a better one.  Many studies have shown that individual investors often get returns that are worse than the mutual funds they own. This is because we (me included) tend to get impatient after a few years of under performance. We then switch strategies just in time to watch the original plan take off like Musk’s Mars bound roadster. Sit on your hands if you feel the urge to change your investment plan!

That being said here is a little mental trick that has helped me. I require myself to consider any money that I apply to some market investment strategy as unchangeable. In other words if I pick a mutual fund or set of mutual funds that I plan to re-balance every year I am going to keep doing that with that money until I need to spend money or am required to change it. However, if I have new money to save I can put it into a different mutual fund or investment strategy of my choosing.

For example, if I bought $10,000 worth of mutual fund A last year but now decide that mutual fund B is better, I can’t just sell my mutual fund A for B. However, if I have more money to sock away I can put it into mutual fund B. Just to be clear I am more concerned that I am not switching investment strategies. If my original plan was to keep a portfolio of 50% A and 50% B I would allow myself to sell some of A and put it into B if A grew to be 60% of the portfolio.

This strikes a nice balance balance of consistency and trying to do better, but may not be the best method for you. Whatever helps you stay consistent do it. The good news is that if you somehow read this whole thing, you have the perseverance of a saint and will do just fine with investing!

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