THE SUPER SIMPLE 401K GUIDE (Part 2): Index funds, Blockbuster vs Netflix, and choosing your 401K

8 min readFeb 4, 2020

In part 1, we learned about where NOT to put your money, and if all you do is avoid actively traded funds, you’ll retire with $20,000–$200,000 extra dollars.

You can read Part 1 here. In part 2, we’ll go over:

What is an index fund
Why index funds consistently perform so well
4 Criteria to choosing your 401k fund
A breakdown of my own 401k fund

Let’s jump right in…

How Index Funds Work

An index fund is a group of stocks that’s based on a category. There are standard categories such as, “Large companies” or “Small companies.” And, there are more creative categories such as, “Socially responsible companies” or “Mixed-source energy companies.”

Here is a breakdown of a few of the most popular types of index funds and what they actually mean:

S&P 500: a collection of the 500 largest companies in the United States
(think Amazon, Walmart, McDonalds, United Airlines, etc.)

Nasdaq Composite: A collection of 2,500 companies in the United States and Europe with 40% being tech companies
(think Apple, Amazon, Netflix, Costco, Kraft Heinz, etc.)

Large-cap: Companies that are valued at more than $10 Billion
(think Microsoft, JPMorgan, Apple, Exxon, etc.)

Mid-cap: Companies that are valued between $2–10 Billion
(think American Eagle, JetBlue, Columbia, etc.)

Small-cap: Companies that are valued between $300 Million to $2 Billion.
(think Shutterfly, Callaway, Upwork, Redfin, etc.)

Each of these funds have positives and negatives. In general, the larger the companies the more stable the fund will be. The smaller the companies the more volatile the fund will be.

The S&P500 tends to be the most popular because it has shown consistent gains over the last 100 years.

**S&P500 Historical Chart**: Notice that after every crisis the index climbs back even higher.

When I was trying to figure out where to put my 401k, my biggest concern was the “set it and forget it” aspect of the whole thing.

What if something terrible happens to some of the companies in the fund?

Would I lose all my money?

Basically, I don’t want to put my money in a company like Blockbuster.

Trading Blockbuster for Netflix

The brilliant thing about these index funds is that even though there isn’t a “portfolio manager” managing them, they are still being “managed” in a way.

Since an index fund has a set of qualifications before it lets companies into the fund, it also uses those qualifications to kick companies out of the fund.

Imagine it’s 1997. Blockbuster is doing great, so it’s in the S&P500.

A few years pass by and Blockbuster sits on its rental fees and doesn’t innovate.

As the company begins to lose it’s value, it drops lower and lower in the index. It drops from spot 155 down to 255.

Then people start renting DVDs and getting them in the mail.

Blockbuster decides to ignore this new trend and lose even more money. So they drop from spot 255 down to spot 455.

Now it’s 2008, and Blockbuster is still alive, but just barely.

Since it isn’t one of the 500 largest companies in America anymore, it gets dropped from the S&P500.

In 2010, the same year that Blockbuster goes bankrupt, the S&P500 adds a new movie rental company to the index: Netflix.

If you had put your 401k in a fund that follows the S&P500, you would have automatically sold your shares in Blockbuster and invested in Netflix without lifting a finger.

This is the beauty of index funds and this why those “portfolio managers” have such a hard time competing with them.

While a portfolio manager is trying to make predictions and guesses about which companies will be best, the index fund simply follows a set of rules and sticks to them.

Of course this isn’t the best system, but is is a consistently good system. And, when it comes to your retirement, a consistently good system is a great system.

Choosing the right Index Fund

Choosing the right index fund can be very overwhelming if you don’t know what you’re looking for.

Most 401ks have dozens, if not hundreds, of funds that you can choose from. And I’m sure that some of them have nuances that make them better than others.

But, getting the perfect retirement fund isn’t the goal of this post. In order to get a perfect retirement fund you would have to read hundreds of prospectus and understand nearly every aspect of investing.

I don’t have time for that and I’m sure neither do you.

Instead, the goal here is to get into a good retirement fund.

The 4 things to look for when choosing a 401k fund

Type of fund: Passively traded fund that follows the (insert name) index.

Expense Ratio: Look for a low expense ratio.
Low expense ratios = .07%-.20%
High expense ratios = .30%-.90%

10-year Annualized Return: This tells you how well the fund performed on average over the last 10 years. Look for returns at least greater than 9% (the S&P500 averages ~9%)

Stock vs Bond ratio: Choose a fund that is made up mostly of stocks and fewer bonds. Since 1926, large stocks have averaged 10% returns vs bonds which have averaged 6%. (around 60% stocks and 40% bonds is considered very conservative. We’ll cover this more in Part 2, but I recommend 90/10).

A Peek Inside My 401K

Here is an example of how I’ve set up my own 401k and the rational behind it:

I chose the Fidelity 500 Index (FXIAX) which follows the S&P500. I chose this because:

Passively Managed? Yes.
Index: The S&P500 has averaged 9–10% growth since it was created in 1926. This historical data also adds confidence to the decision compared to a new index that hasn’t been tested yet.
Expense Ratio: The fund has an expense ratio of .01% which is much lower than even the recommended .07%.
10-Year Annualized Return: The fund has a 13% average return which is even higher than the recommended 9%.
Stock vs Bond Ratio: 100% stocks. Since I’m relatively young (age 30), I’m okay with the risk of having 100% stocks. If the stock market crashes, I have many years to wait for it to recover.

The last point here is fairly important. Most people read about economic crashes and get scared of investing in the stock market. Or, even worse, they sell their stocks exactly during a financial crisis.

If you’re doubtful about putting your 401k in the stock market like I was, hopefully this next section convinces you otherwise. Let’s take a look at some exciting historical data…

Why (some) People Lost their Retirements in 2008

Let’s take a worst-case scenario as our example. Imagine you invested all your money at the height of 2008, when stocks were more expensive than ever before and right before the financial crisis hit.

If you invested $100,000 into your 401k in April 2008, here is what would have happened depending on when you chose to cash out:

If you had panicked and sold at the absolute bottom of the crisis…
Feb 2009: Lost $47,000

If instead you had held on just 1 more year…
April 2010: Lost $16,000

If instead you had held on for 5 years…
April 2012: Lost $6,000

If you had held on for 10 years…
April 2017: Gained $51,000

If you had never sold and still had your 401K…
Dec 2019: Gained $94,000

If you had been patient and just waited a few more years after the crash, your $100,000 would have actually grown to more than $194,000.

The reason that a lot of people “lost their retirements” in 2008 was because they couldn’t wait for the economy to recover.

And this is fair.

Sometimes life gets in the way of our plans and we are faced with adverse circumstances we need to deal with. Sometimes we need to cash out that 401k to pay for living expenses, or college, or a home, or medical expenses.

That’s why it’s always best to have a safety net in addition to a 401k for those short-term circumstances where you have to wait for the economy to recover.

That’s it for part 2. In Part 3 we’ll go over: