I nvesting in a 401(k) plan at work can be a lot like eating at a cheap buffet. There are a lot of options, but theyre all bad. For those trying to hard to keep investing costs down and to invest with a solid asset allocation plan. having bad options in a 401(k) or 403(b) is like finding a long strand of hair in your soup.

A listener of the Dough Roller Money Podcast recently emailed me about some obstacles they were encountering with their workplace retirement plan:

My name is Rasiel, I have been following your 31-Day Money Challenge podcast series and it has been like drinking from the firehose. Thank you for such a good job.

I just changed jobs and Im not sure my new 401k is good enough. I was hopping it had a few stock and bond low-cost index funds I can use to easily and cost effectively setup my portfolio but Im having a hard time finding a good balance.

My current company has its 401k with Fidelity NetBenefits. (I have attached the options in the plan, as well as the portfolio I have been working on).

My first thought -in order to make it simple- was to pick a Target-Date fund (I expect to work another 30 years, so FFFIX seemed like a good alternative)

The only problem with FFFIX is that its expense ratio is 0.78% and this 401k also has a 0.50% Administrative Fee associated with it, so I have spent a good time researching and trying to come up with a portfolio with a smaller Weighted Avg. Expense Ratio.

Im 35, Im a Software Engineer and I love what I do. I expect to retire around 65-70 so Im ok being aggressive and I understand the risk associated with it.

My questions:

1. I have came up with a 80/20 portfolio with the options I have in my plan. I reduced the expense ratio from 0.78 to aprox 0.55. Im not sure though about the bond part of the portfolio. 15% is in short-term bond (which bogle heads favor) and 5% World Bonds. I would feel better with some mid-term bonds, but there is none in the plan. Should I be worried? If so, should I revert back to the Target-Date?
2. I can go 85/15 by moving 5% from the bonds to REITs (my plan has this option Fidelity Advisor Real Estate I Report (FHEIX) | Asset Allocation Summary) _however_ there is no international REITs in my plan, just US. Would this be a problem?
3. Im rolling my old 401k over to Vanguard. In the case neither the Target-Date or the one I have came up with are good enough, should I consider using only the funds that are cost-effective in my plan, and balance with the IRA in Vanguard?

Thank you for all the valuable information you have put together.

Rasiels email raises an interesting question about 401(k) plans.  If the plan you have at work doesnt offer any good investment options, or only offers one or two decent choices, what should you do? In this article well cover 4 options you have to make the best of a bad 401(k). (In the podcast of this article, I also address the three specific asset allocation questions raised in the email.)

Evaluation Your 401(k) Investment Options

The first step is to evaluate the investment choices that are available in your 401(k).  For each mutual fund, youll want to determine the following:

1.  Asset Class.  Youll first want to determine what asset class each investment covers. This can be trickier than it may seem. The three primary asset classes are U.S. stocks, international stocks, and U.S. bonds. Thats simple enough.

Yet within each of these broad asset classes are many sub-asset classes.  For example, a small cap U.S. stock fund invests in just small public companies in the U.S. not the entire universe of U.S. companies.  In contrast, a total stock market fund or even an S&P 500 index fund has far more coverage of the U.S. market.

Think of it like a set of Russian dolls.  A total stock market index fund is the largest doll. Lift it up and youll next find an S&P 500 index fund. Lift up that doll and youll find smaller dolls that cover less of the U.S. market, like mid-cap, small-cap and other niche funds.

The point is to understand what each fund covers.  The goal is to design a portfolio that covers each of the three broad asset classes mentioned above. A small cap fund by itself doesnt accomplish this goal in terms of U.S. stocks. A total stock market fund or even an S&P 500 index fund does. In other words, look for the bigger dolls.

(For you investing ninjas, yes you can construct a portfolio with small cap. mid-cap and large-cap funds.  You can even add in value and growth funds, REITs. commodities, and the like. In other words, you can ditch the big doll and replace it with a bunch of smaller dolls that add up to a big doll.  I found, however, that a simple portfolio is better.)

2.  Expense Ratio. The cost of investments is a critical factor in selecting mutual funds.  As weve covered before, the cost of mutual funds can easily add up to tens of thousands of dollars or more over a lifetime of investing.  Thus, its critical to know how much each mutual fund costs.  The expense ratio will be available in the funds prospectus and the fund companys website.  If you cant find it, call the company that manages your 401(k) plan.

As a general rule, we want to find index funds that cost 25 basis points (100 basis points = 1%) or less.  As for actively managed funds, look for options that cost 1% or less.

3.  Target Date Options. Finally, take note of any target date retirement options you have and how much they cost.  Most 401(k) plans today offer these fund of funds, although they are not all created equal.  As Rasiels email noted, the Fidelity target date funds cost about 78 basis points.  While this is below average, Vanguard offers target date funds for much less.  Of course, Vanguard funds may not be an option for you.

With this data in hand, we can now turn to the four 401(k) investment strategies.

Four 401(k) Strategies

1. Sniper Approach. Find just one or two good investment options. This wont allow you to cover all three major asset classes (U.S. stocks, international stocks, and U.S. bonds). In some cases youll only find investments for one of these asset classes. However, you then use investments in an IRA or taxable account to fill the holes.

For example, perhaps your 401(k) offers an excellent S&P 500 index fund that can cover U.S. stocks for your portfolio. You invest your 401(k) money in that index fund.  Then, in an IRA or taxable account you invest in funds that cover international stocks and U.S. bonds.

The advantage to this approach is clear. You invest only in good options within your 401(k). You ignore the bad options and let your other investments pick up the slack.

The sniper approach has a few downsides. First, you must have other investment accounts to round out your portfolio. If your 401(k) is your only investment, or you dont have enough money in the other accounts, this approach wont work.

Second, rebalancing across multiple accounts can feel like herding cats. As soon as you get one account squared away, you realize two others have peed all over the floor. This is where keeping an investment portfolio simple with as few funds as possible can make life a lot more pleasant.

2. The 3-Fund Approach. If you can find decent options for each of the three main asset classes, create a portfolio that doesnt rely on outside investments. The key here is to find reasonable investment options, not necessarily the best investment options. For fans of index funds, this approach usually requires you to consider actively managed funds.

This is the approach I now take in my 401(k). Heres my current portfolio:

• 40% International StocksDODFX (Dodge and Cox International Stock Fund)
• 40% U.S. StocksFXSIX (Fidelity Spartan 500 Index)
• 20% BondsVBTLX (Vanguard Total Bond Market Index Fund)

Total Weighted Average Cost: 29 basis points

Note that DODFX is an actively managed fund that charges 64 basis points. I happen to think that its an excellent fund (which is temporarily closed to new investors), but it does cost more than Id like to pay. Yet overall this is an excellent portfolio, in my opinion. In just three funds I cover the major asset classes at a low cost. Rebalancing is a snap as I dont have to look to outside investments in my IRAs or taxable accounts.

3. Target Date Retirement Funds. Most 401(k)s offer target date retirement fund options. These fund of funds give you a well diversified portfolio in a single fund. Its like buying a package vacation that includes airfare, hotel, and food all in one.

The key here is to examine the costs. As noted in the email above, Fidelity offers these funds for just under 80 basis points. While this cost is not ideal (Vanguard offers similar funds for less than 20 basis points), its a reasonable choice if the Sniper or 3-Fund approach is not workable given your investment options.

4. BrokerageLink. The final option is available in many 401(k) accounts managed by Fidelity. Through BrokerageLink. you can invest in many options that arent otherwise available in your 401(k). There are additional transaction fees associated with BrokerageLink. If your 401(k) does not offer other reasonable options, however, BrokerageLink may be your best choice.