Start with your time horizon and risk tolerance

The core decision in picking 401(k) investments is matching how long you have until retirement with how much your account value can swing year to year. If you retire in 40 years, your portfolio can weather a 30% drop in a bad market year because you have decades to recover. If you retire in five years, that same drop could force you to work longer or cut spending.

Risk tolerance is personal. Some people sleep fine during market downturns; others panic and sell at the worst time. Be honest about which you are. Your 401(k) plan documents usually include a questionnaire that estimates your tolerance, but your own gut reaction to market news is often more accurate than any quiz.

Once you know your timeline and comfort level, you can narrow the investment menu. A 25-year-old with 40 years to retirement can hold mostly stocks. A 62-year-old with five years can hold mostly bonds. Most people fall somewhere in between and hold a mix.

Key Takeaways

  • Your time until retirement and how much portfolio swings bother you determine whether you should hold mostly stocks, mostly bonds, or a mix.
  • Target-date funds automatically shift from stocks to bonds as you approach retirement, so they require almost no ongoing decisions.
  • If you pick individual funds, you need to rebalance once a year—selling winners and buying losers to stay on your original plan.
  • Lower-cost index funds (expense ratios under 0.20%) outperform most actively managed funds over 10+ years, especially after fees.
  • Your plan's investment menu is limited; you cannot buy any fund you want, only what your employer's plan offers.

Target-date funds do the rebalancing for you

A target-date fund is a single fund that holds a mix of stocks and bonds chosen for people retiring in a specific year—usually labeled "Target 2055" or "Target 2060." The fund automatically shifts from mostly stocks when you are young to mostly bonds as you approach that year. You buy it once and do not touch it again.

Target-date funds are the simplest path for most people. You pick the fund closest to your actual retirement year, and the fund manager handles rebalancing. You pay one expense ratio instead of managing multiple funds. The tradeoff is that you have no control over the exact mix—if the fund is 70% stocks and 30% bonds but you want 60/40, you cannot adjust it.

Check your plan's target-date fund lineup. Most large employers offer them. If your plan does not, or if the available target-date funds have high expense ratios (above 0.30%), you may want to build your own mix instead.

Building your own mix with index funds

If you want more control or your plan lacks good target-date options, you can build a portfolio from individual funds. The simplest approach is a three-fund portfolio: a U.S. stock index fund, an international stock index fund, and a bond index fund. You decide the split between them based on your timeline and risk tolerance, then hold that split.

An example for someone 30 years from retirement might be 70% U.S. stocks, 15% international stocks, and 15% bonds. Someone 10 years from retirement might be 40% U.S. stocks, 10% international stocks, and 50% bonds. The exact percentages matter less than picking a mix you can stick with during market downturns.

Index funds track a market index—the S&P 500, the total U.S. stock market, or the total bond market—rather than trying to beat it. They have low expense ratios, usually 0.03% to 0.15% per year. Over 10 or 20 years, this cost difference compounds. A fund charging 0.05% per year will have thousands more in it than an identical fund charging 0.50% per year, all else equal.

Your 401(k) plan lists the expense ratio for every fund in its menu. Look for funds under 0.20%. Avoid funds charging more than 0.50% unless your plan offers nothing cheaper.

Rebalancing once a year keeps you on track

If you build your own mix, you need to rebalance once a year. Rebalancing means selling the funds that have grown and buying the ones that have shrunk, so your portfolio returns to your original split. If you started with 70% stocks and 30% bonds, but stocks have risen so much that you now hold 80% stocks, you sell some stocks and buy bonds to get back to 70/30.

Rebalancing forces you to sell high and buy low, which is the opposite of what most people do naturally. It is also the reason many people outperform those who chase performance. You do this once a year, usually in December or January, by logging into your plan and moving money between funds. It takes 10 minutes.

If you use a target-date fund, the fund manager rebalances for you. You do not have to do anything.

Avoid these common mistakes

The most common mistake is chasing performance. A fund that beat the market last year often underperforms the next year. Switching to last year's winner usually means buying high and selling low. Pick a mix based on your timeline and risk tolerance, then leave it alone except for annual rebalancing.

The second mistake is holding too much in company stock. If your employer offers company stock as an investment option and you work there, you already have company risk in your salary and benefits. Holding 20% or 30% of your 401(k) in company stock concentrates that risk. Most financial advisors suggest keeping company stock below 10% of your portfolio, if you hold it at all.

The third mistake is holding cash or money market funds as your main investment. Money market funds pay interest close to the current savings account rate, usually 4% to 5% in 2024, but that rate changes with the Federal Reserve. Over 30 years, stocks have returned roughly 10% per year on average, and bonds roughly 5% to 6%. If you are decades from retirement, cash will not grow fast enough to meet your goals.

Understanding expense ratios and fund types

Every fund in your 401(k) plan charges a fee, listed as an expense ratio. This is the percentage of your money the fund takes each year to pay managers, administrative costs, and trading. A fund with a 0.10% expense ratio charges $10 per year on a $10,000 balance. A fund with a 1.00% expense ratio charges $100 on the same balance.

Index funds have the lowest expense ratios because they simply track an index and do not require active managers. Actively managed funds employ managers who try to beat the market. They charge higher fees—often 0.50% to 1.00% or more. Over long periods, most actively managed funds underperform index funds even before fees. After fees, the gap widens. Unless your plan offers an actively managed fund with a proven track record and an expense ratio below 0.30%, index funds are the better choice.

Your plan may also offer stable value funds, which are insurance contracts that may provide a fixed return, usually 2% to 4%. These are safer than stock funds but less likely to grow your money over decades. They are useful as a small portion of a conservative portfolio, but not as your main holding if you are young.

What to do if your plan's options are limited

Some smaller employers offer only a handful of funds, and some of those funds may have high expense ratios or poor performance. If your plan is limited, work with what you have. Pick the lowest-cost stock fund and the lowest-cost bond fund available, even if they are not perfect. A mediocre fund at 0.40% per year is better than sitting in cash at 0.01%.

If your plan is truly bad—all funds charge over 1.00%, or the menu is so narrow you cannot build a reasonable mix—consider whether you can contribute less to the 401(k) and put more into an IRA instead. IRAs have no employer restrictions and let you choose from thousands of funds. However, if your employer matches contributions, always contribute enough to get the full match first. A 50% or 100% match from your employer beats any fee savings from an IRA.

Frequently Asked Questions

Should I pick a target-date fund or build my own portfolio?

Target-date funds are simpler and require no ongoing decisions. Pick one if your plan offers good options with expense ratios below 0.30%. Build your own mix if you want more control, your plan lacks target-date funds, or the available ones charge high fees. Both approaches work if you stick with them.

How often should I change my investments?

Rebalance once a year to stay on your original plan. Do not change your overall mix based on market news or performance. If your life changes—you get closer to retirement, your risk tolerance shifts, or your financial situation improves—you can adjust your mix, but this should happen rarely, not monthly or quarterly.

What if I do not know my retirement date?

Use your expected retirement age. If you think you will retire around 65, pick a target-date fund for 2055 or 2060 depending on your current age. If you are unsure, a slightly more conservative mix (more bonds, fewer stocks) is safer than a too-aggressive one, because you can always take more risk later.

Can I move money between funds without penalty?

Yes. Moving money between funds within your 401(k) plan has no tax penalty or cost. You can do it as often as you want, though rebalancing once a year is usually enough. Do not confuse moving money between funds with withdrawing money from the plan—withdrawals before age 59½ usually trigger taxes and penalties.

Why do some funds have much higher expense ratios than others?

Actively managed funds charge more because they employ managers and analysts. Index funds charge less because they simply track an index with minimal management. Higher fees do not mean better returns. Most actively managed funds underperform index funds over 10+ years even before fees are subtracted.