Once you’ve determined the percentage you’re allocating to an asset class, you must decide how to invest the money that percentage represents.
For example, if you’re assigning 60% of your contribution to equities, and your 401(k) offers eight equity funds, you must decide which funds to use and whether to emphasize one rather than another or put money equally into each of your choices. There are no fixed rules for what’s best.
The key is to identify funds that invest in different segments of the equity market: large companies, small companies, companies that seem poised for growth, and those that are ready to make a comeback. You might also consider an index fund, a balanced fund, or a fund that invests internationally. That way, you’re in a better position to benefit from whichever of those segments of the market is performing best. Then follow the same approach for choosing bond funds, though you are likely to discover there are fewer of them in your plan.
You won’t necessarily want to use all the funds your plan offers. There’s little benefit to owning two funds that invest similarly, as two large-cap growth funds might, since owning the two provides no additional diversification. In fact, it can be as counterproductive to over-diversify as it is to put all your money into just one or two investments. The problem with spreading yourself too thin is that relatively little money goes into each fund, making it harder to accumulate a substantial account value.
| What’s in a Name? While a fund’s name is often a useful clue to its investment style, don’t take it at face value. Look at the fund’s prospectus using the EDGAR database on the SEC Web site, and check to see how the fund is classified by research companies. If a fund with "Small company" in its name has substantial investments in medium- and large-sized companies, it may not have all the diversification you’re seeking when you buy it.
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