401k retirement savings plans are terrific ways to save for retirement. They use the power of investment and compound interest to deliver tremendous returns based on how much you put in each year. By the time you are able to withdraw your funds without penalty – at the age of 59 ½ – the percentage of your total amount that was accumulated by your investments absolutely dwarfs the amount you put into it out of your monthly salary.
In other words, you’ll make far more for retirement with a 401k than you would simply by saving your money and putting it into a low-yield savings account. Plus, the fact that you gain access to free money through employer contributions is a huge bonus.
Still, having a 401k means you have to make certain decisions involving your investment allocations. Where should you put your money? What are the pros and cons of the options available to you? There are nearly two dozen investment options; which is the best for you? Here, I’ll cover the main five – stocks, bonds, mutual funds, certificates of deposit, and money market accounts – and give you an overview for each one.
Money Market Accounts
I’ll start with money market accounts, because they are generally the safest option available. A money market account works by paying interest on your money when it is placed into money markets, or markets that buy and sell Treasury bills, bank certificates of deposits, federal funds, commercial paper, and the like. It’s a short-term market, not a long-term market like bonds and stocks.
Money market accounts deliver lower rates than other options, but they beat the return you’d get by having your money sit in a savings account or checking account. The advantage is that they are generally viewed as safe places to put your money because they are insured by the FDIC and aren’t very volatile.
Pros: Low volatility and risk; insured by FDIC
Cons: Lowest rate of return
Certificates of Deposit
You can also allocate your money into certificates of deposit, which are financial products that give you a certain rate of return if you keep your money in them for a certain period of time (called a fixed term). You can find CDs that have terms of one month, three months, six months, one year, or more – up to five years, in most cases. They deliver a predictable rate of return that can be higher than what you receive with a money market account if you go for longer maturities.
The downside, again, is that they do not offer nearly as high a rate of return as some other options. Additionally, CDs are susceptible to inflation because they are not very liquid if you go for bigger returns through longer terms. Rising inflation can eat into and even vanish your gains.
Pros: Low risk; insured by FDIC
Cons: Not as profitable as most options; susceptible to inflation for long terms
Bonds as an asset class offer a step up from either of the two mentioned above. Heading into this territory can be a bit tricky, though, because there are several types of bonds out there. In general, there are three types most 401k participants use: municipal bonds; Treasury bonds; and corporate bonds.
Treasury bonds (T-Bonds) are issued by the U.S. Treasury and are viewed as the safest investments in the world because they’re backed by the U.S. government. They come in three flavors, depending on their maturity: T-Bills (mature in one year or less); T-Notes (mature in 2-10 years); and T-Bonds (mature in 20-30 years). T-Bonds and T-Notes both pay what is called a coupon payment every six months; this amount is a percentage of the note’s value paid to you. Collectively, all three of these are called Treasurys.
Rates of return (called “yields”) for these vary; historically, they have underperformed stocks (except from 2002 to 2011, when they actually outperformed stocks by a significant amount).
Municipal bonds are similar to T-Bonds in that they are issued by a government agency and come with a term, a maturity, and a fluctuating interest rate. Most municipal bonds are considered quite safe and generate decent returns, but they vary considerably because not all cities and local governments are created equal. These generally return lower rates than all other bond types. But – and this is a big but – these are usually exempt from federal, state, and local taxes.
Corporate bonds offer the largest rates of return, typically, and are issued by corporations as a way to finance their operations. They are similar to the other two bond types, but have a higher risk of default than either. Of course, that’s why they also offer better returns.
Pros: T-Bonds are the safest investments you can make; less risk than stocks; predictable returns
Cons: Less liquid than the above assets; outperformed in most years by stocks; subject to some volatility; default wipes out value
A mutual fund is a collection of assets that you can own under the umbrella of the fund. Most are managed professionally, either actively – a fund manager trades assets regularly for maximum return – or passively – they are tied to an index or have some automated way to change asset allocation. You can find mutual funds for virtually every asset class, including bonds, money markets, and stocks. Your average investor pictures stock-based (or equity) mutual funds when they think of the term.
Mutual funds typically offer better returns than bonds, CDs, or money market accounts but smaller returns than investing in a pure stock portfolio. They are safer than stocks, though, and also give you the chance to easily diversify your portfolio, which insulates you a bit from downturns in the market.
Mutual funds, though, come with fees that are paid regardless of if the fund performs well. Plus, you don’t have control of what assets the fund owns.
Pros: Better return than bonds and the other above asset classes; diversification; safer than stocks
Cons: Lower returns, on average, than stocks; subject to volatility and risk
Finally, we are at the main asset most people think when they picture using their 401k assets to invest: stocks.
Stocks typically offer a far greater return than any other asset class and are very flexible. From 2006 to 2011, stocks routinely topped the charts of the annual returns of several benchmark asset classes, bested usually only by gold. You can buy shares of stock in thousands of companies across the world, and this stock can be sold quickly and easily for cash, making it a very liquid asset.
The disadvantages of stocks, though, are considerable. For starters, it takes some experience and knowledge to pick the right stocks. You can remedy this somewhat by choosing an exchange-traded fund that is traded like a stock but covers several different assets. Also, stocks are volatile and generally the riskiest assets, with the possible exception of credit default swaps, high-yield “junk” bonds, and other similar assets. You can lose far more, on average, with stocks than you can with bonds, mutual funds, or any other asset class.
Choosing stocks is for people who want more of an aggressive strategy in their 401k portfolio.
Pros: Usually offer the highest rates of return; liquid; provide thousands of choices
Cons: Volatile; riskier than the other major asset classes; harder to invest in successfully
Which One Should You Pick?
Ideally, you should have a well-rounded, balanced, and diversified portfolio with a little bit of everything thrown in. Bonds and money market accounts and certificates of deposits provide some balance against a turbulent stock market and give you a safe harbor for your money; stocks give you the earning power that can turn your contributions into a sizable nest egg.
You need a little of all to truly make your portfolio successful. But, the degree to which you choose one asset over the other is largely dependent on your risk profile.