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Finance 101: Your 401(k) Investment Primer

By Clifton Linton Senior Writer, mPower

For many folks, a main goal of their working life -- on top of career accomplishments -- is to construct a solid retirement. The 401(k) plan is the toolbox they use for this job. The plan holds the tools (investments) used to build savings.

Building a retirement account can be challenging. It rarely comes with a blueprint, and there is no certain outcome. Yet many workers have little investing experience before saving in their 401(k). They may not understand how to use the tools.

"Of the folks we talk to, many are not familiar with the selections in their 401(k) plan and are not sure how their money is invested," said Janet Fox, president of ACH Investment Group Inc.

Here's an overview of these tools that you can refer to as you embark on this lifelong do-it-yourself project.

The 401(k) Plan

Despite what some workers think, a 401(k) plan is not an investment. It is a tax-advantaged retirement savings account into which you (and sometimes your employer) make pretax contributions. You use the money you contribute to the 401(k) to purchase different investments that are offered by the plan. Most 401(k) plans offer workers a variety of investments. The most common one offered is the mutual fund.

Mutual Funds

A mutual fund is a pooled investment. Your contributions and those of the other investors in the fund are used to purchase a variety of securities, such as stocks or bonds. Rather than owning the securities, you own a share of the fund. The fund's manager picks the securities the fund invests in and decides when to buy and sell them.

Mutual funds are well suited for 401(k) plans because they are diversified -- they invest in many securities. Long-term investors, such as retirement savers, usually want to diversify their portfolios because it helps smooth out their returns by reducing investment risk -- the fluctuation in an investment's value.

Choosing a Fund

How do you select the best mutual fund (tool) for you?

The task may seem daunting -- especially if your 401(k) offers a lot of funds. But, most 401(k) plans offer funds that hold securities from one of three general asset classes: stocks, bonds and cash. Some funds hold a mix of stocks and bonds and are called balanced funds.

Like screwdrivers, pliers and hammers, each of these investment types, or asset classes, is made for a specific job. When you have the right mix, it becomes easier to build your retirement.

	"Of the folks we talk to, many are not familiar with the selections in their 401(k) plan." Janet Fox, president of ACH Investment Group Inc.

If you read the prospectuses of all the funds offered in your plan, you'll soon see that many of the offerings are really variations on a theme. For instance, a small-cap fund or an emerging growth fund are both stock funds, but they only hold specific types of stocks. To get a broad representation of the stock market, you may need to buy several funds or look for a more general fund among your offerings.

Types of Funds

A stock or equity mutual fund invests primarily in stocks -- ownership in a business. Stocks earn a profit as follows: when the company succeeds, the stock price goes up and it may issue dividends to distribute profits to shareholders. If the company hits hard times, the stock price falls and dividend payments may be suspended. When you sell a stock, you earn money if it has gained value since you bought it; you lose money if it has declined. Stocks don't provide a guaranteed return, and tend to be riskier investments than bonds and cash. But for the risk that you take in investing in stocks, you gain the chance to receive higher rewards. Historically stocks have generated higher returns than bonds and cash over time.

With a stock mutual fund, your reward is based on the performance of all the securities held by the fund rather than of a single stock. Most mutual funds (stock, bond or cash) select investments according to a stated investment goal and strategy, contained in the mutual fund's prospectus.

Figuring out what kind of fund you are being offered isn't always easy. Sometimes the fund name says what assets it holds, sometimes not. In either case, it's a good idea to look at the fund's prospectus and read the investment policy, which will be specific.

For instance, the popular Vanguard 500 Index fund's objective states: "the fund seeks to match the performance of a benchmark index that measures the investment return of large-capitalization stocks."

To put it simply, this fund invests in the largest stocks traded in the U.S. It attempts to match the performance of the Standard & Poor's 500 index, a stock market benchmark.

Some funds may invest primarily in growth stocks (shares of companies poised to grow rapidly in the near future) or value stocks (stocks of firms that are mature and whose assets outweigh their liabilities). Other funds specialize in stocks of small companies (small-cap), medium-size companies (mid-cap) or large companies (large-cap). Some, called international funds, invest in overseas companies.

A bond fund invests primarily in bonds, which are basically a loan to a corporation or government. When you buy a bond you become the lender. The bond seller agrees to pay you interest and to repay the amount you loaned it by a certain time (the maturity date). Bonds typically mature in two to 30 years.

Bonds are less risky than stocks, but not entirely without risk. One reason: a rise in interest rates can cause bond prices to fall, thus reducing the value of your investment.

Rather than putting its eggs in the basket of a single bond, a bond fund invests in many. The fund profits from the interest payments it receives on the bonds it owns and by selling bonds whose price has risen.

As with stock funds, bond funds come in different flavors. Some funds only invest in U.S. government bonds, which are the safest in the world. Others invest in bonds issued by corporations, which can be pretty safe. A common reason why investors buy bond funds is to provide stability to their portfolios. Some funds invest in high-risk corporate bonds, called junk bonds, which provide less stability and a higher potential return along with their higher risk.

A cash investment, such as a money market mutual fund, typically invests in short-term debt securities, such as certificates of deposit and U.S. treasury bills that mature in one year or less. Because the probability of repayment of these securities is high, when you invest in a cash security, it pays very low interest rates and tends to have the lowest risk of any investment. Cash securities are designed to not increase or decrease in value.

Another common type of fund offered is a stable value or guaranteed investment contract (GIC) fund. These are also low-risk investments, commonly offered by insurance companies. They generally have better returns than cash, but lower returns than bond funds.

You generally don't want to buy only one mutual fund. In most cases you want to invest in at least several, to diversify your mutual fund holdings. One exception would be if you invest in a lifecycle fund, which contains a pre-set mix of stocks and bonds geared toward your age, and is designed to be the only fund in which you invest.

Company Stock

Many employers offer company stock as a matching contribution to their 401(k) plan and/or as one of the plan's investment choices. Company stock had advantages and disadvantages. For most retirement savers it has one big disadvantage that outweighs all the advantages: it is a high-risk investment, simply by virtue of being an individual stock (as opposed to a mutual fund).

If you have a large chunk of company stock in your 401(k) portfolio, you are taking a big bet on your company. If your employer does well, so will your stock. But, if your company falters, as Enron and WorldCom did, your retirement portfolio could be at great risk.

That raises the question: is company stock a reasonable investment to add to your 401(k) portfolio?

	"In most situations, the risk of holding company stock tends to be so high that it doesn't make sense." Hal Ratner, vice president, investments, mPower Advisors LLC.

If you have a choice, probably not, said Hal Ratner, vice president of investments with mPower Advisors LLC.

"In most situations, the risk of holding company stock tends to be so high that it doesn't make sense," he said.

mPower is the publisher of this site and provides investment advice to retirement plan participants.

If you don't have a choice, you can select other investments in your plan to help offset the company stock risks.

Investment Risk Tolerance

Bonds, stable value and cash may seem like the best options because they have low risk. But, low-risk investments, with their corresponding low returns, may not provide you with a comfortable retirement. Stocks historically have given the highest potential return over the long term.

What's the best mix of investments? The answer is different for each person.

Before picking funds, you need to create an investment strategy based on your savings rate, your age, your retirement date, retirement goals and your tolerance for investment risk.

Risk tolerance is your ability to tolerate a loss. How you would feel if your retirement portfolio fell by 10 percent, 20 percent or more?

	"We buy when we feel good and sell when we feel bad." Barbara Pietrowski, CPA and CFP

Ratner offers a general guideline: "the longer your time horizon, the more risk you should take." When you save over a long time, you have the ability to recover from market shocks.

Those with a time horizon of at least 10 years should have more of their portfolios in stocks, while those with a shorter time horizon should have more in bonds, he adds.

"An Educated Consumer"

A clothing retailer uses the slogan "an educated consumer is our best customer." The same applies to investing.

What many 401(k) savers don't realize is that their emotions often cause them to make bad investment decisions. "We buy when we feel good and sell when we feel bad," said Barbara Pietrowski, a CPA and CFP based in Kensington, Md. "When the market goes down we don't sell. The losses mount. At the point of maximum pain (when the market is near its lowest point), you sell."

You can learn more about investing by reading the newspaper, investment prospectuses and books, attending employer seminars and taking continuing education classes.

Education can help you insulate yourself from your emotions.

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The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.
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