Making the Best 401(k) Mutual Fund Choices

By Ric Lager

My primary parenting approach has always been to encourage my kids to work hard and dedicate themselves to achieve any goal they had their heart and mindset on. When my son graduated with an MBA in Spring 2020, he set off to find his dream job; working for a top-tier investment bank on Wall Street.

Ric Lager

All my boring and repetitive mini-lectures paid off. In early 2021 he got hired at one of his top picks.

Quickly, the conversations with my son turned to how to best manage his generous package of employee benefits. I told him that if I had received even half of these benefits at his age, I would not be working as hard as I am today.

My first investment management lesson was to advise him to contribute the maximum amount he could in pre-tax dollars to all employee benefit accounts, specifically his company 401(k) retirement plan account.

I told him that funding his 401(k) to the maximum amount would be the easy part. Taking a hands-on investment management approach to managing his company 401(k) account would be more difficult.

The truth is, all of the company 401(k) provider propaganda in the world regarding asset allocation, diversification, and auto-enrollment does not answer the investment management decision required by a company 401(k) retirement plan participant.

For my son in his first job with not one dollar invested in his company 401(k) account, he needed the answer to only one question:

What do I buy?

When my son asked me this, I immediately thought about all of the investment management mistakes I had seen individual company 401(k) investors make over the long course of my career.

I opened my first individual company 401(k) investment advisory account in 1999. Since then, I have reviewed hundreds of individual company 401(k) account statements from dozens of company 401(k) retirement plan mutual fund menus.

I see the same company 401(k) investment management decision mistakes repeatedly. Most of the individual company 401(k) retirement plan participants attempt to “diversify” or use some level of “asset allocation.” The result is small company 401(k) positions in several laggard mutual funds that underperform the stock market averages.

Even worse are the increasingly popular target-date mutual funds. These company 401(k) options have been overly-hyped as a “set-it-and-forget-it” solution for long-term company 401(k) account investment management decisions.

In many company 401(k) retirement plan menus, a target-date mutual fund is the QDIA (Qualified Default Investment Alternative). When you contribute to a company 401(k) plan, you need to direct those contributions to a specific mutual fund option. If you don’t, your company 401(k) retirement plan contributions, and company-matching contributions, are directed into a QDIA mutual fund.

My advice is to pay more attention to the investment management decisions required to manage your company 401(k) retirement plan account. Don’t settle for someone else making your investment choices; put a little time in and do your homework.

Regardless of the number of company 401(k) mutual fund options on your menu, there are no more than a handful of mutual funds that outperform in any stock or bond market environment. These mutual funds go up more when stock markets rise and interest rates fall.

More importantly, this same handful of outperforming mutual funds hold their value much better during stock market declines or a rise in interest rates.

I asked my son the following common-sense question, “if you are going to take all the risks associated with stock and bond market investing, doesn’t it make sense to put yourself in a position to receive the commensurate investment returns?”

My son nodded in agreement. But I still didn’t tell him “what to buy.”

The next company 401(k) investment management lesson I provided to my son was the calculation of “the cost of the problem.” I have developed this strategy in order to help individual retirement plan participants calculate how much it has cost them to own the wrong mutual funds on their company 401(k) retirement plan menu.

There is always a huge investment performance gap between the best and worst mutual funds on your company 401(k) menu. The problem is that no independent third party has ever helped you calculate the dollar value of that gap.

The “cost of the problem” analyzes the financial consequences of understudied and inattentive 401(k) mutual fund decisions. Remember the reference target-date mutual funds? Over your working career, there is a huge dollar amount of financial impact of owning the wrong mutual funds.

All company 401(k) mutual fund menus have poor mutual fund options, and I didn’t want my son to fall victim. More importantly, I wanted him to be aware of the problem before he made his first 401(k) mutual fund decision.

We analyzed my son’s default company 401(k) menu. We found the information on the last three, five, and ten-years investment performance on each mutual fund option.

Next, we calculated the value of a $10,000 investment at the end of each of those time frames. The results were eye-opening for my son.

In more than one example, at $10,000 investment in one of the best mutual fund options on his company 401(k) menu would have been worth 30 to 40 percent more than the same amount “diversified” into another mutual fund option over the same time period.

This exercise is not hard, and anyone is capable of this same level of investment management decision-making. Each time you receive your quarterly company 401(k) retirement plan account statement, take ten minutes to identify the names of the top handful of mutual funds ranked by recent investment performance.

Use the S&P 500 stock market index as a benchmark. Every company 401(k) menu has this mutual fund option. In your company 401(k), this index represents “the market.”

Divide your company 401(k) menu options into two groups: those mutual funds that have “outperformed” the S&P 500 over the last few quarterly or yearly periods, and those that have not.

At the inception of your young stock and bond market investment career, this is the best advice I can provide. That is, make sure that all your company 401(k) retirement plan account dollars are at all times invested in a mutual fund that is beating “the market”—the S&P 500 index.

During some economic and stock market cycles, the best mutual funds are aggressive growth funds. During other cycles, the best mutual funds are conservative and blended stock mutual funds. There may even be a cycle when the combined stock and bond formula in a target term mutual fund is the best company 401(k) investment management strategy.

You don’t have to guess. You just need to pay attention on a regular basis; either with your paper quarterly statements or a few minutes online.

If you perform near or slightly above the historical performance of the S&P 500 beginning early in your career, you will be a long-term company 401(k) investment management winner. The growth and preservation of your retirement nest egg will not be assured, but it sure as heck will be better than many of your peers.

Once those top mutual fund options on your company 401(k) retirement plan menu are identified, then you can think about asset allocation, diversification, and dollar-cost-averaging into those mutual funds.

The “cost of the problem” calculation results in a much more profitable long-term buy-and-hold 401(k) investment management strategy. Would you take ten minutes every calendar quarter to have a couple hundred thousand more dollars? My son is on the right track now to begin his company 401(k) retirement plan account contribution.

Now he knows how his dad would make those investment management decisions if he could do it all over again, with the benefit of 20-20 hindsight and painful mutual fund choice lessons along the way.

About the author: Ric Lager

Ric Lager is president of Lager & Company, Inc., a registered investment advisory in Golden Valley, Minnesota. In 2020, Ric produced an online CLE course titled, “An Expert’s Perspective: Individual 401(k) Management for Attorneys.” Ric is also the author of the book, “Forget the Pie: Recipe for a Healthier 401(k).”

By Ric Lager

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