By Mike Lewis

NEW YORK (Money Crashers) — Unless you are self-employed, the investment choices for your 401(k) are established by your employer. While you have at least three options, the average plan offers eight to 12 investment alternatives, including the default investment if you fail to make a choice, according to the Financial Industry Regulatory Authority.

Debbie DeMatteo, chief investment officer for investment adviser 10-15 Associates, claims that 40% of plans even offer brokerage accounts, which means you can choose from a full range of stocks, bonds and managed and unmanaged funds, as well as other types of investments. This plethora of choices can be a problem when determining which path is best to achieve your retirement goals.

Your fund management philosophy

Benjamin Graham, Warren Buffett's mentor, believed there are two kinds of investors:

  • Active or "enterprising" investors. These people are willing to invest the time and effort to understand the complexities of various investments and keep current on the economy and events affecting those investments.
  • Passive or "defensive" investors. Such investors lack the time or inclination to make a substantial personal commitment to managing their investments and are willing to accept an average market return or pay someone else to manage their funds.

Graham, who has been called the "father of investment analysis" and the "Einstein of money," detailed his philosophy and methods in two classic books, Security Analysis written in 1934 and The Intelligent Investor in 1949. His three principles of investing remain valid for anyone seeking to maximize their investment returns.

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  • Invest with a margin of safety. Graham believed that minimizing downside risk was just as important as seeking high-return opportunities. He advocated keeping a portion of each portfolio (25% to 75%) in fixed-income securities, depending upon prevailing market conditions.
  • Expect volatility and profit from it. The price of investments reflects human emotions, not necessarily the true economic value of the underlying asset. Graham advocated diversification to reduce portfolio risk as well as regular periodic investment as a method to resist emotional pressures or group-think to buy or sell securities.
  • Know what kind of investor you are. Are you an active or passive investor? Do you spend time daily keeping up with your investments? Weekly? Monthly? Do you do your own research or rely upon others? Do you listen to contrary opinions or go with the herd? Understanding your own capabilities, limitations and risk tolerance can help you decide on the investment strategy that is best for you.

Graham also pointed out that while speculation (buying an asset in anticipation that someone is going to pay more for it later) and investment (buying a piece of a business and letting it grow) are different investment philosophies, being successful in either approach requires considerable expertise and experience. In other words, passive investors are unlikely to beat the market's average return as either a speculator or investor.

Investment strategy for maximizing returns in a 401(k)

The purpose of a 401(k) is to encourage savings for retirement by creating a fund that can be used to supplement Social Security payments when you are no longer working. As a consequence, the fund enjoys tax deferrals on interest, dividends and capital gains as well as an income tax deduction for contributions up to an annual maximum ($17,500 last year). You can instead contribute after-tax funds to some 401(k) plans (known as Roth contributions) that allow for tax-free withdrawals at retirement.

1. Maximize your annual contributions

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Participating in your employer's 401(k) automatically provides a number of advantages to increase your investment return, including:

  • Investing with pretax dollars
  • Deferring taxes on capital gains, dividends, and interest
  • An employer match on the first 6% of contributions for more than half of plan participants, according to the Bureau of Labor Statistics

As a consequence, most investors do not need to take exceptional risk to build a significant retirement portfolio. For example, if an employee makes an annual contribution of $3,600 that is matched equally by his or her employer, and it compounds annually at 7.35%, that employee will build a portfolio of $306,696 in 20 years. (7.35% is the average annual return for the stock market for the past 10 years.)

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2. Diversify your investments with funds

If you have been an "active" investor and have failed to consistently achieve returns better than the S&P 500, consider buying and holding the following:

  • A portfolio of unmanaged Exchange-Traded Funds. Many investors acquire a portfolio of ETFs (including a broad-based market index ETF such as the S&P 500) to participate in select industries, reduce country or currency risk and diversify their portfolios to minimize the impact of adverse cyclical events.
  • A professionally managed, balanced mutual fund. Managed funds also consider market timing when deciding what securities to buy or sell and when to act, but include the added cost of management fees. If you use an independent adviser or invest in a managed fund, be sure you consider the "net" results, the return after fees and commissions have been deducted. A managed fund which cannot beat general market returns is rarely a good investment.

3. Adjust your portfolio allocation for your age

As you near retirement, the time to grow asset value (as well as your appetite for risk-taking) naturally diminishes. Your primary focus should be to maintain the value of your investments, instead of aggressively seek to grow them, as time is no longer on your side. Many advisers recommend a portfolio allocation where the percentage of fixed-income, low-risk investments is equal to your age. In other words, at age 60, your portfolio should be 60% fixed income, 40% equities; at age 65, 65% fixed income, 35% equities. Like all stock market advice, the percentage allocation you decide upon should be adjusted to your particular circumstance and comfort level.

Final thoughts

While many investors have begun to use their 401(k) accounts as personal trading vehicles, it is not advisable for the average employee. Buying and holding a fund, managed or unmanaged, that delivers the average market return or better, coupled with regular contributions over a period of 10 to 20 years, can build a comfortable nest egg to supplement retirement. If your employer makes a matching contribution, so much the better.

How do you choose funds for your 401(k)?

Mike Lewis is an active investor with a strong background in business, entrepreneurship, and economic policy.