How to best invest in 401(k)s, IRAs

Most workplace retirement plans offer a variety of investment options, ranging from low risk—such as money market funds—to high risk, like stock funds, with many flavors in between.

Knowing which of these offers you the best chance to earn a decent return can be confusing and daunting. Here I’ll explain how to invest in a way that can help you reach your retirement goals.

Balefire9 | iStock /360 | Getty Images

Balefire9 | iStock /360 | Getty Images

Your current contributions: Simply put, the best way to invest the money that’s regularly deducted from your paycheck is to invest in stock funds.

Too risky, you say? That might appear to be the case when we recall that, during the 2008 credit crisis, the Dow Jones Industrial Average fell 54 percent in just 18 months.

However, I’m not talking about investing a lump sum in the market at once. Instead, you’re putting in only a small amount from each paycheck, a strategy known as dollar cost averaging. If the market happens to be down at the time your contribution goes in, it simply buys more stocks—as if buying them on sale! Later, when the market bounces back, you will enjoy a greater profit.

I often espouse the importance of having a well-diversified portfolio, owning a wide range of asset classes for the long term. That’s diversification by asset class. Dollar cost averaging is simply diversification by time.

Here’s an example of how this might have worked during the 2008 crisis: If you invested at the market high on Oct. 9, 2007, and stopped there, your balance would have been down 54 percent at the low on March 9, 2009, and you wouldn’t have returned to the break-even point until March 5, 2013.

But if you were contributing regularly all that time—say, $1,000 a month—your loss on March 9, 2009, would have been about a third less than the Dow’s, and you would have recovered your losses by January 2011—more than two years before the Dow itself did.

What’s wrong with the other choices available in your plan? Some, including bonds, cash and other types of assets, might be appropriate later, when you’re ready to diversify the money you’ve accumulated, but stock funds deliver the best returns for your new contributions.

Instead of trying to choose which individual stock funds will perform best, invest in as many stocks as possible that vary by style (growth and value), cap (large, medium and small), sector (type of industry or geographical location) and so on.

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You’ll invest in all of these through mutual funds or—preferably, if you can—exchange-traded funds, which offer many advantages, including much lower cost.

If, instead of a 401(k), your employer offers another type of retirement plan—such as a 401(b) or 457—stock funds are still your best option. Fixed annuities usually provide low returns. Variable annuities are just mutual funds wrapped in insurance, making them far costlier, unless your company offers groups of annuities, which can be lower in cost.

Your employer’s contributions: If you’re investing your paycheck contributions entirely in stock funds, it only makes sense to invest your employer’s match the same way.

Consider this example: Say you contribute $100, and your employer adds $25. If you’re in the 30 percent tax bracket, your contribution is tax deferred, so it costs you only $70. You now have $125 invested. Even if your investment fell 44 percent, you’d still have all of your original investment. If it doubles in value, your profit would be 330 percent when the match is taken into consideration.

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Money already in your plan: Over time, you’ll begin to notice that you have accumulated a significant amount of money.

Is it wise to keep 100 percent of it exclusively in stocks? Not if you’re nearing retirement and will need the money within a few years. Imagine the disappointment of someone who had kept everything in stocks in 2008 and planned to retire in 2010.

Don’t expose yourself to such a risk.

“The best way to manage your existing account balance is to reallocate it into an appropriate mix of funds and asset classes that meets your desire for growth and your tolerance for risk.”

Instead, my colleagues and I agree that, while you should continue to invest 100 percent of your new contributions in stock funds, the best way to manage your existing account balance is to reallocate it into an appropriate mix of funds and asset classes that meets your desire for growth and your tolerance for risk.

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And then you must rebalance your portfolio at reasonable intervals to maintain that appropriate mix. Otherwise, it will tend to drift from the ideal.

If all this sounds like more than you are willing or able to handle by yourself, I suggest that you talk to a fee-based, objective financial advisor who can help you make wise choices leading to a comfortable retirement.

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