Saving for retirement is hard. Knowing how to invest and manage your retirement savings might be even harder — and more important. The good news is there are increasingly new and better tools to help individual investors make good choices and automate the management of funds at a low cost.
Here is a guide to traditional investments — investments most commonly used — for retirement accounts.
Most financial professionals agree that investment returns are largely driven by how your portfolio is allocated (what type of investments you make) and the diversity within those allocations.
An ideal retirement account might have a mix of stocks, some bonds and – perhaps also a bit of exposure to commodities or real estate. And, your stock holdings would be diversified in a variety of companies in a range of industries and you might hold an assortment of bonds — some short term and some longer term for example.
This type of diversification is intended to protect your savings from big losses and optimize your returns based on your time horizon and risk profile.
- Time horizon: When do you need the money? If you have a long time horizon, you might make different investments than if you need the money next year.
- Risk profile: Risk profile refers to how well you can you tolerate the volatility or ups and downs that come more with some investments than others.
Below are the three most common investment choices for retirement savings – equities (individual stocks or funds), bonds or fixed income (debt) and commodities (raw materials used to make things).
Stocks are a type of investment that enables you to buy a piece of a particular company and get returns based on the performance of the company.
Stocks are appealing because they typically offer the best rate of return. They are also fairly easy to understand. If you own a share of Coca Cola, you know what that means.
However, stocks also have the highest risk and volatility. It can be risky to tie your fortunes to one company.
That is why it is important to keep your stock portfolio diversified. Typically you want to hold a variety of stocks in different sectors. Sectors include: energy, financials, materials, industrials, utilities, information technology, telecommunication services, consumer discretionary, consumer staples and health care. Investors should also consider factors like international diversification (US vs International) and the size of a firm – large cap or small cap (basically big and small firms).
So, for example, if you were buying Coca Cola, you might not want to also own Pepsi or Clorox. Both Pepsi and Coca Cola sell bottled drinks, but they are also both part of the consumer staples sector — along with Clorox. Furthermore, all three stocks are large cap stocks and have international exposure.
Pros and Cons of Owning Individual Stocks:
- Pros: If you pick the right company, you can see big gains.
- Cons: If you pick the wrong company, you could lose a lot of money. Crafting an adequately diverse portfolio can be confusing and risky.
An efficient way to gain diversity is to avoid individual stock purchases and instead buy mutual funds, Exchange Traded Funds (ETFs) or another type of fund that automatically give you diversification.
As the late Vanguard founder, John Bogle, said, “Don’t look for the needle in the haystack. Just buy the haystack.”
Mutual funds and ETFs enable you to buy a collection of stocks, bonds or other securities with one purchase. There are a wide variety of funds that you can buy, some options include:
- Sector Funds: Instead of buying stock in one company in one sector, a sector fund enables you to invest in a variety of companies in one sector.
- International Funds: These funds invest in companies around the world. You can choose funds focused on a particular region or country or something covering all markets — including the United States.
- Index Funds: Index funds invest in most or all of the companies included in a specific index. An index is simply a list of stocks.
- Exchange Traded Funds: These are usually index funds that are lower cost — usually commission free.
- Target Date Funds: These are funds designed to maximize returns on a certain date in the future.
- Target Allocation Funds: These are funds that maintain a fixed asset allocation.
- Money Market Funds: These funds are considered low risk. They invest in treasuring bills and certificates of deposits.
- Commodity Funds: These are funds that invest in raw materials used to make things like Gold, Oil, Copper, Coffee, etc.
- Glide path funds: These are managed funds that are managed to match your risk tolerance.
There are many other mutual fund and ETF options.
The main advantages of mutual funds and ETFs are that they enable you to buy a wider variety of holdings than you might be able accumulate on your own and the trading of those investments are done for you.
The downside can sometimes be high fees associated with actively managed funds. And, while it is safer to own a fund rather than an individual stock, your money is still subject to the rise and fall of financial markets.
When you buy a bond, you are loaning money to a company or government by buying it’s debt.
In exchange for your money, you get regular interest payments and the assurance that your money will be paid back, in full. Bonds don’t offer the same upside as stocks, but they are lower risk since they are backed up by the assets of the entity. In a worst case scenario if a company goes bankrupt and liquidates a stock, the investor often gets nothing, but a bond investor will be in line with other creditors to get paid through the sale of company assets.
Bonds can be issued by a company, a city, state or the federal government.
You can buy individual bonds or more commonly bond funds (mutual funds or ETFs). The major risk for bond investors are interest rate increases – since if you own a bond that is paying 3% interest and then interest rates go up and bonds are now paying 5% – then no one wants to own bonds at 3%. If you are willing to hold your bond until maturity (the time it pays off) then it’s not that big a deal – you just collect less interest. If you decide to sell your 3% bonds though you will likely take a capital loss on the sale.
These are raw materials or agricultural products that can be bought and sold.
This is another way to get exposure to the overall economy – over the past several years as emerging economies like China’s have grown then have been big buyers of commodities to build out the infrastructure and manufacturing bases – which has helped support commodity prices. Holding a small part of your portfolio in commodities can be a good way to balance out a portfolio.
An annuity is technically an insurance product, but they are often thought of as a retirement investment that can guarantee income and eliminate unknown risks.
For example: when you buy a lifetime annuity, you are exchanging cash for a guaranteed income stream that will last as long as you are alive.
Annuities are complex products, but it may be worth your while to get an instant lifetime annuity estimate and learn about their pros and cons.
No. Money can be invested in almost infinite ways. And there are an array of less traditional retirement investments that may be a better fit to you and your goals.
So, how do you make choices? Before investing your money for retirement, you need a clear understanding of your retirement plans. When will you retire? How much money will you need? When will you need it?
The NewRetirement Retirement Planner can help you answer these questions. Working with a financial advisor is another option. Best of all, an advisor can also help you determine your investment strategy.
