What’s Your Risk/Reward Appetite as a Investor?
A 401(k) account can be a powerful tool to help you plan and save for retirement. But should you decide what you should invest in to ensure the best outcomes? It comes down to education. To maximize your 401(k) earnings, you need to understand the types of investments offered by your plan and pick and choose the options that are most suitable for you.
What’s most suitable? It depends on your long-term goals, your age, your income and more. But, despite the variability, there are some standard rules of thumb around 401(k) to get you started on the right track.
Risk vs return
As an investor, you and you alone know how much risk you’re willing to take on. For instance, you could choose to keep your money in a low risk, low return savings account to avoid big losses. You won’t lose anything, but you won’t gain much either. (Many interest bearing accounts don’t even pay enough to keep up with inflation, so you’re actually losing a little each year.) This decreases your buying power in the future.
Another option is to put your money into fixed income assets such as bonds, which are low risk because they offer a steady return. But again, you face the same problem. Bonds don’t always appreciate very much.
For bigger returns, you need to invest in other, often riskier, assets. Stocks are risky because their value goes up and down (sometimes on a daily basis). But in the long run, stocks typically provide strong returns.
There’s no investment that is low risk and high return. This means that you have to make a tradeoff between protecting yourself from loss and potential earnings.
The relationship between age and risk
The younger you are, the more risk you can take with your 401(k) investments. Because retirement is decades away, time is on your side. This means that you can benefit from higher long-term growth stocks. You also have more time to recover from market dips and temporary stock value loss.
However, as retirement nears you’ll want to re-evaluate your investment mix. When retirement is just a few years away, it’s best to move your money from stocks and into safer investments, like bonds.
By lowering your portfolio risk, there’s a much lower chance of losing a ton of your money due to a big market drop right before you’re set to retire.
Annuities, bonds, and similar investments are also beneficial in that they provide a steady source of retirement income. Only dividend-paying stocks provide income during retirement.
The rule of 100
In deciding how much of your portfolio to keep in stocks vs bonds, use the rule of 100. Simply subtract your age from 100, and then put that percentage of your portfolio into stocks. The younger you are, the larger percentage of your portfolio should be in stocks.
But because the average life expectancy is increasing, bonds are offering lower concerns. If you want to be less conservative with your portfolio, subtract your age from 110 or 120.
Whether you use the rule of 100 or 120, what’s important is that you rebalance your portfolio each year. The best approach is to make gradual shifts as you near retirement.
From risk appetite to portfolio construction
Once you’re comfortable with how much risk you’re willing to take on, it’s time to choose investments that meet your needs and appetite.
A target-date fund is a unique mutual fund that most 401(k) plans offer. Also known as lifecycle funds, these funds invest your portfolio into a variety of stocks, bonds, and cash. Investing is dead simple. Just choose a fund that has a target year that’s closest to the year that you anticipate retiring. You’ll have an instantly diversified portfolio that’s designed for where you are in life and where you’re going down the road.
When starting out, your portfolio will be stock heavy (assuming retirement is decades away). Over time, it gradually shifts to lower-risk bonds and then cash as you near your target date. Using a target-date fund makes investing your 401(k) much easier, as your funds will be shifted automatically. There’s no need to rebalance each year, as the fund does all of the work for you.
Diversification is a must
One of the best ways to reduce your risk is to diversify your portfolio. This means spreading your money across several investments. With a diversified portfolio, if one of your investments falls, you won’t lose everything.
Stocks vs. bonds – Choose a mixture of stocks and bonds based on your risk tolerance. When the stock market is high, bond returns fall, and when the market is low, bond returns increase. With a combination of stocks and bonds, there will always be an investment that’s doing well.
Foreign vs. domestic – You can also divide your stocks between domestic and internal stocks. If an international market falls, you have U.S. investments to protect you from significant losses.
Large vs. small – U.S. stocks can be divided into large-cap, mid-cap, and small-cap companies. Large-cap companies are the big industry leaders. Mid-cap stocks are medium sized companies, and small-cap stocks are for small companies as well as start-ups.
Small-cap stocks are less stable but have the potential for immense growth.
Developed vs. emerging markets – You can choose to put some of your foreign stock investments into emerging markets in less developed countries. Though riskier than developed markets, these stocks can offer big gains.
Within these categories, you can diversify even more by investing your funds in ETFs, index funds, or even alternative investments.
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