401 (K): Index Funds

Lately, with the economy moving forward like a tipsy drunkard, it seems best to try and eek out every little gain that you can. For those fortunate enough to have a little bit in a company sponsored retirement account like a 401(K), there are still quite a few ways to make sure you’re getting the most out of your money.

Most managed 401(K)’s tend to offer a small selection of different types of funds to choose from. While you might also be able to make a few investment choices within your specific plan, I’ll be limiting my topic to how best to select from the limited options presented to most people with a 401(K). Given the option between a few types of funds, what metrics can be used to determine how to best proportion your money between them. While you’ll have to decide for yourself between large cap, small cap, or some other exotic index of funds, there is one item that can be used to compare similar funds. This useful metric is the expense ratio of the fund.

Since most mutual funds historically tend to underperform the broader markets over the long-term, some of the less risky options are the Index Funds, or mutual funds that emulate the stock market indices. Because they merely attempt to stay within a narrow parameter set by the market index, there is far less management involved in the fund and consequentially less expenses. This leads to most Index Funds having expense ratios well below 1%. Comparatively, most actively managed mutual funds have expense ratios of around 2% with some even higher than 5%. Over the long run, these expense ratios will eat into your potential gains. Now why would you want to pay more for likely less gains?

So, while you may agonize over which mutual funds had the best return over the past three or five years, be aware of the nickel-and-diming that goes on with some of these funds. Past performance is only an indicator of future returns if you’re a politician. Index funds may not be the best option for everyone’s 401(K) plans, but it does offer some of the smallest risk relative to other stock funds. Granted you still need to decide how to balance your contributions relative to which indexes, but if you’re a passive investor keeping down the costs is one of the easiest things to do.


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