A 401(k) is a special type of retirement account that employers can offer as a benefit to their employees.

Your 401(k) investment options are determined by the company that manages the 401(k) account in collaboration with your employer. This means the optimal 401(k) investment strategy will vary depending on your employer, as each employer offers different products.

However, there are some considerations for any 401(k) plan, and indeed any investment account you open.

What are my choices?

Most 401(k) plans offer a variety of mutual funds for you to invest in. Most plans also offer the option to deposit funds into a money market account, which is similar to a savings account but with very low interest rates. Unless you’re close to retirement, depositing your 401(k) into a money market can actually result in losses due to inflation, so you should look into the mutual funds offered instead.

Mutual funds are investment vehicles that allow you to spread your funds across a variety of stocks, bonds, or both. Mutual funds can focus on specific types of businesses, holding stocks only in healthcare companies, for example, or only in large corporations. They can also focus on specific types of bonds, holding only U.S. government bonds or only high-yield corporate bonds.

Index funds are a type of mutual fund that holds a diversified portfolio of stocks representing an entire stock index, such as the S&P 500 index. These stocks represent a variety of business types, making index funds a great way to diversify your investments.

Target-date funds are another type of mutual fund designed to help people plan for retirement. When you’re early in your life, you have a long time to wait until normal retirement age. This means you can afford greater risk and volatility with your retirement savings in pursuit of higher returns. As you approach retirement, you can’t afford as much risk or volatility because you’ll need to spend that money soon.

Target-date funds help you plan for retirement by initially holding a large portion of high-risk, high-return stocks and transitioning to holding more low-risk bonds as the target date approaches.

For example, if you plan to retire in 2060, you could purchase a “2060 Target Date” fund, which might hold stocks and bonds in a 90/10 ratio right now. By 2030, this ratio might be 80/20, and by 2060, it might be 50/50.

Target-date funds are great for setting and forgetting your retirement savings because they automatically adjust risk according to your needs.

Diversification

As mentioned earlier, the mutual funds offered by 401(k)s allow you to invest in multiple stocks and bonds at once. But just because you have a lot of stocks doesn’t mean you’re diversified. If the mutual fund you invest in only holds stocks from a specific sector, events disproportionately affecting that sector could harm your investments.

For example, banks were severely impacted by the 2008 financial crisis, but companies providing necessities like utilities were less affected. If your mutual fund only holds banking stocks, you’d suffer significant losses. If you invest in a mutual fund holding stocks from all sectors of the economy, your losses would be less.

Another form of diversification to seek is international diversification. Just because you live in the U.S. doesn’t mean you should only invest in U.S. companies. The same goes for wherever you live. You can invest in any publicly listed company on Earth, regardless of where they’re located. While international investing has its own pitfalls, investing in mutual funds holding some international stocks can indeed provide additional diversification that might help if your domestic market slows down.

If your 401(k) doesn’t offer a fund that allows you to diversify across all types of investments you want, you’re free to invest in multiple funds. While this might be more complicated to manage, diversifying your investments is worthwhile.

Fee Structure

Mutual funds make investing easy but come with a cost for that convenience. Mutual funds charge fees that allow them to operate and generate profits for the companies managing the funds. Depending on the size of the fees, they can indeed affect your overall returns.

Load Fees

Load fees are fees you pay when you buy or sell investments. Front-end loads are fees you pay when you buy. Back-end loads are fees you pay when you sell. These fees are typically charged as a percentage of the transaction, so a 2% front-end load means you only get $98 worth of mutual fund for every $100 you invest. Similarly, a 2% back-end load means you’d only get $98 for every $100 you try to withdraw.

The good news is, fees are relatively minimal in 401(k) investing, and there are usually ways to avoid them, such as holding investments for a certain period before selling.

Expense Ratio

Expense ratios are more common than load fees because all mutual funds charge them. They reflect the costs incurred by the fund manager in operating the fund.

Expense ratios are also expressed as a percentage, representing the total investment you pay annually to maintain your investment in the fund.

Expense ratios aren’t explicitly charged, so you won’t see fees taken out of your account for paying them. Instead, the figure is automatically factored in when the fund manager calculates the per-share value at the end of the trading day.

Some funds have low expense ratios, less than 0.1%. Others have expense ratios of 1% or higher. While 1% might not sound like much, it can have a significant impact over time.

This example illustrates how expense ratios can drag on your overall returns.

You start working and plan to invest $5,000 annually, earning a 10% return for 40 years. After 40 years, you’d have $2.66 million.

If you invest in mutual funds with a 0.1% expense ratio, you’d earn a 9.9% return annually. After 40 years, your balance would be $2.58 million, $80,000 less than if there were no expense ratio.

If you invest in funds with a 1% expense ratio, your annual return would be 9%. By the end of the 40-year period, your balance would reach $2 million. These fees would reduce your wealth by over $600,000. That’s why you should look for low-cost investments that suit your risk profile. Even small fees can have a significant impact.

You can use Personal Capital’s 401(k) Fee Analyzer to determine how your investment options’ fees affect your overall returns.

Rebalance Regularly if Necessary

If you haven’t opted for target-date funds that automatically manage the allocation of stocks and bonds or if you’ve invested in multiple funds, sometimes, rebalancing is necessary.

When you first invest, you decide what percentage of your funds to allocate to each fund. Over time, the actual investment amounts in each fund will change based on the funds’ performance. Bonds might perform well one year while stocks perform poorly.

Rebalancing involves transferring funds between funds to maintain the asset allocation you’ve decided on. As you approach retirement age, you’ll also need to reassess the allocation you’ve determined.