When you enroll in a 401(k) plan you're usually presented with an array of different investment options. People often associate 401(k) plans with the stock market. While your plan probably contains a lot of stock options, it also contains some good old- fashioned cash accounts.
Every mutual fund has a stated investment strategy and fund companies try to create a variety of investment options so that everybody's need are met. Aggressive mutual funds mostly contain stocks. These funds are particularly volatile because your account value can skyrocket during market booms but tank during economic downturns. Conservative funds hold items such as U.S. Treasury bills and corporate debts. You earn interest on bonds and this causes the account to slowly grow over time but you don't typically see the kinds of gains and losses that you associate with an aggressive funds. Moderate funds are halfway house investments containing both stocks and bonds. The stocks provide you with the chance for growth while the bonds provide a measure of stability during market downturns.
Mutual funds usually include at least one cash option. These accounts are similar to the types of savings accounts you get at banks except they are not federally insured. You earn a small amount of interest while avoiding the risks that are associated with other types of investments. A cash option may appeal to you if you plan to take out a 401(k) loan so you can buy a home or pay for educational costs. You can safeguard the money you'll need ahead of time by trading out your mutual funds for cash. Doing this means you won't have to worry about a stock market downturn wiping out your nest egg.
Money Market Funds
Aside from cash accounts, many 401(k) plans include money market mutual funds which are known as cash equivalents. These funds contain low risk securities such as short-term federal treasury bills. You earn dividends on these shares that sometimes exceed the interest payments on actual cash accounts. In theory, money market fund shares should always remain steady at a price of $1 per share. However, some funds have broken the buck and share prices have fallen below $1. Also, these funds like other mutual funds are actively managed by investment professionals. You pay an annual fee known as an expense ratio to cover the fund's operating costs. On some occasions, fund fees can exceed the dividend payments which means you actually lose money on your investment.
People nearing retirement often decide to quit while they're ahead and trade their mutual funds for cash so as to preserve their earnings. If you plan to let your 401(k) grow for another 30 years you might lose money if you make this move too soon. Cash accounts expose you to inflation risk which is the danger that the cost of living will rise more quickly than the value your 401(k) holdings. You can't buy as much with a dollar today as you could 20 years ago. Therefore, 401(k) cash accounts are not risk free investments.