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Here's exactly how to pick investments for your 401(k)

Twenty/20

Investing in a 401(k) is one of the main ways many U.S. workers build up savings for retirement. Its tax-advantaged status and automated contributions make it a particularly valuable financial instrument, and those who are able to start investing early are more likely to end up a millionaire.

Yet while opting into your company's 401(k) plan is a relatively easy process, only about a third of Americans understand how the account actually works, according to a recent poll from ValuePenguin. That can cause people to put off investing all together.

If you don't know how to invest through your 401(k), here are six tips to get you started.

1. Understand what a 401(k) is

Just 37% of Americans say they can define what a 401(k) is, according to a recent survey. But not knowing what the account is can harm your ability to save and invest effectively.

A 401(k) is a retirement investment account offered by your employer. It is what's known as a "tax-advantaged" investment account: The money you contribute to it each year, typically a percentage of each paycheck, lowers your taxable income. That tax break is meant to encourage you to save for retirement now.

There is also a Roth 401(k), which is offered by fewer employers than a traditional account. You contribute money that's already been taxed; then, when you withdraw money in retirement, you do not pay taxes. For more on the difference between a traditional and Roth 401(k), read this article.

Like a savings account or individual retirement account (IRA), a 401(k) itself is simply a type of financial account. Once you contribute money to your 401(k), you must then invest the money in stock or bond funds, otherwise it will remain as cash.

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While you sign up for your 401(k) through the company you work for, it is typically managed by a separate financial firm, such as Vanguard, Fidelity, Principal, Schwab, etc. This is the company you will receive important information and disclosures from about your account and investments.

If you leave your employer, in most cases your account will remain at the financial firm that originally managed it, unless you roll it over to a new company (or have contributed little to it).

You can begin withdrawing money penalty-free at 59 ½ in most cases. If you withdraw money before that age, you will be hit with a 10% early withdrawal penalty and pay income taxes on the distributions. You can also take a 401(k) loan, which needs to be repaid, including interest. Learn more about that here.

Not every employer offers employees a 401(k). If that's the case, you can open an IRA, which also offers tax advantages for those investing for retirement, on your own through a brokerage firm.

2. Determine how much you can contribute

Workers under 50 can contribute up to $19,500 to a 401(k) in 2020, but how much you actually earmark for the account depends on your income, debt level and other financial goals. Still, financial experts advise contributing as much as you are able to, ideally between 10% to 15% of your income, especially when you are young: The sooner you start investing, the less you'll have to save each month to reach your goals, thanks to compound interest.

Here are two scenarios that illustrate why it's so advantageous to start early:

  1. You start investing at 19 and contribute $2,000 to your account every year until you reach 27. From 27 to 65, you contribute $0. Assuming a 10% rate of return, you would have $1.02 million by 65.
  2. From 19 to 26, you don't invest anything. You start investing at 27 and contribute $2,000 to your account every year until you turn 65. Assuming a 10% rate of return, you would have $805,185, despite contributing for more than 30 years longer.

Companies often offer a match on contributions up to a certain dollar amount or percentage (the average employer 401(k) match is 4.7%). Financial experts advise contributing at least up to the employer match threshold. Otherwise, you are leaving money on the table that your employer owes you as part of your total compensation.

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"That's your company literally saying: 'Hey, here's some free money, do you want to take it?'" financial expert Ramit Sethi told CNBC Make It. "If you don't take that, you're making a huge mistake."

3. Calculate your risk tolerance

All investing is risky and returns are never guaranteed, but it can actually be more risky to keep too much of your savings in cash, thanks to inflation.

Still, you don't want to go all in on one stock or investment, particularly if a rocky market makes you uneasy and anxious, or likely to do something drastic, like pull your money out of your account.

You'll want to determine an appropriate asset allocation, or how much of your investments will be in stocks (also known as equities) and how much will be in "safer" investments, like bonds. Stocks have the potential for greater returns, but can be more volatile than bonds. Bonds are more stable, but offer potentially lower returns over time.

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Financial advisors often recommend using the following formula to determine your asset allocation: 110 minus your age equals the percentage of your portfolio that should be invested in equities, while the rest should be in bonds.

But think about your investing horizon. If you have decades until you're going to retire (or take distributions), then you can afford a bit more risk. You might choose an 80-20 stock mix for now. When you're older, you'll start scaling that back, depending on your goals and, again, your appetite for risk. Experts suggest checking that your investments are properly aligned with your risk tolerance each year and rebalancing as necessary, though how often you actually do will vary based on personal preference.

If you're still unsure, you can also take the Investment Risk Tolerance Assessment created by personal financial planning professors Dr. Ruth Lytton at Virginia Tech and Dr. John Grable at the University of Georgia.

4. Pick your investments

Once you start contributing money to a 401(k), you then have to choose investments. Otherwise, your contributions will sit in a money market account.

Typically, you cannot invest in individual companies — such as only buying stock in Amazon — through a 401(k). Instead, you'll select one or more mutual funds or exchange-traded funds (ETFs), which invest in a variety of companies and sectors. There are thousands of funds available in the financial market, but your company's 401(k) plan will only offer a small selection of stock and bond funds, ranging from conservative to more aggressive. That's often for the best, because too much choice can overwhelm investors and actually hurt your returns.

No matter how many funds you're offered, you'll need to do a bit of research before you make your selections. One way to assess each fund you're offered is to search its name via Morningstar, an investment research firm. On Morningstar's site, you'll be taken to a profile page for the fund, which will list its fees, performance over time and what companies, sectors, stocks and/or bonds make up the fund. Morningstar also provides a star rating for each investment's performance.

You can also search the fund's name on Google, suggests Tass Zigo, an Illinois-based certified financial planner, to research the holdings (what companies comprise the fund), its allocation (the split between stocks and bonds) and more.

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"One thing I definitely don't recommend doing is looking at last year's performance and just investing in the best performing fund from last year," Ryan J. Marshall, a New Jersey-based CFP, tells CNBC Make It. You want to take a longer-term view: Look at five and 10-year returns for a better idea of how the fund has performed over time.

You should also pay attention to the fees, particularly the expense ratio, which should be below 1%. The expense ratio refers to how much you are charged for investing in a certain fund.

"Costs really matter in investments," investing icon Warren Buffett told CNBC in 2017. "If returns are going to be seven or 8% and you're paying 1% for fees, that makes an enormous difference in how much money you're going to have in retirement."

Over the past few years, mutual fund and ETF expense ratios have been trending down, which is a win for investors. You can find funds tracking the S&P 500 with expense ratios of hundredths of a percent. In 2018, the average expense ratio of passive funds was 0.15% (and 0.67% for active funds), per Morningstar. Some brokerages even offer zero-fee index funds, though those might not be available in your 401(k) plan.

Beyond fees, you also want your investments to be diverse, or spread across different sectors. You can likely achieve this diversity and low cost via an index fund. These funds follow a market benchmark, like the S&P 500, so they cover large swaths of the market and are inexpensive for financial companies to manage. Investing in index funds is known as "passive investing," because fund managers aren't actively picking companies they think will perform well; they're simply following a stock index.

It's a strategy Buffett recommends. "Consistently buy an S&P 500 low-cost index fund," he said. "I think it's the thing that makes the most sense practically all of the time."

An index tracking the S&P will give you exposure to large U.S. companies, but you can also add an international fund and a fund that invests in smaller companies for broader exposure.

Just make sure you're comparing "apples to apples," says Marshall. "If there are three different international funds, you will want to review the expense ratios and historical long term performance."

5. Go with the simplest option

Alternatively, you can opt for a target-date fund, which takes most of the guesswork out of the equation. With these funds, you select a "target" retirement year and risk tolerance, and the fund is automatically set to an appropriate asset allocation for you. These are great options for beginner investors.

"Most people aren't interested in researching [and] selecting funds for their 401(k)," Charles C. Weeks, a Philadelphia-based CFP, tells CNBC Make It. "Target date funds will help people avoid blowing up their portfolios by making avoidable mistakes like putting too much in one asset class, chasing returns by investing based on past performance and/or letting greed and fear dictate their investment strategy."

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Over time, the fund will automatically rebalance, becoming more conservative as you near retirement. If you choose a target-date fund, you only need to choose the one fund — otherwise you're essentially canceling out its benefits. Another mistake to avoid with target-date funds is choosing a year without researching how it will change its mix of stocks and bonds over time, Howard Pressman, a Virginia-based CFP, tells CNBC Make It.

"Someone may find that they would like a more or less risky mix of investments than what's in the target-date fund they are considering," says Pressman. "In that case, they can select a date farther into the future for more risk, or sooner for less. Don't get too bogged down on the date, but consider the general mix of stocks and bonds."

6. Scale up contributions over time

Once you've picked your investments, the best thing you can do is leave your account alone and let the contributions build.

In addition to low costs and diversity, consistently investing over time — i.e., every paycheck — will make the biggest difference in the size of your savings. Low-cost funds are only effective if you continuously invest in them and don't try to time the market, or pull money out when it starts to drop, a recent report from Morningstar says.

Experts also advise increasing your contributions each time you get a raise or bonus (assuming you haven't already hit the annual contribution limit) by a percentage point or two, helping you reach your goals faster.

Finally, remember that while the stock market has historically increased around 10% per year, that's not guaranteed, and there will be periods when it falls. Experts also expect returns to be lower, around 4%, over the next decade than they have been the previous 10 years.

Still, no one knows what will happen, except that the best course of action is typically to invest in low-cost index funds consistently, over many decades. Do that, and you'll be on the path to building real wealth.

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