Date Created: Apr 26, 2005, 08:16 AM
Updated: May 20, 2008, 9:36 AM
So now that you've enrolled in your company's retirement plan (if not, please read my other article: 401K, 403(b), SIMPLE IRA's, SEP, huh? first) you may be a little overwhelmed with your choice of investments and the prospectus documents your benefits department gave you. You'll hear terms like Asset Allocation and Diversification being bandied about. All you care about is making the most money without losing your shirt.
There's no one plan that can match everyone's needs, but I'll do what I can to help make your decisions easier. The most important factors to keep in mind are: how long until you plan to retire and what is your personal threshold for investment risk. These two can be, but aren't necessarily, related. Typically the longer you plan to work, the more risk you can probably stomach. By risk I mean the frequent ups/downs the market takes and the possibility of losing money in the short-term. The longer your money sits in investments, the less relative risk they incur since the overall economic and market forces have been on an upward trend more often than not when you measure it in decades. Day to day market movement of course looks like a roller coaster at your nearest Six Flags.
So what is Asset Allocation and Diversification? Asset Allocation is the art of spreading your investment assets to maximize your return on investment (ROI) while keeping within your personal risk threshold. Diversification is the process by which you spread those assets among different investment categories, industries, and even countries to minimize your relative risk. So what does this mean for your retirement account? Old cliché's work best here: Don't put all your eggs in one basket!
With choices like Equity Funds (Large Cap, Mid Cap, and Small Cap stock based mutual funds... Large Cap consists of large companies, Small Cap consists of small companies), Bond funds, Money Market Funds, Value Funds, Index Funds, etc., it's hard to know where to put your money. What is usually suggested for a well diversified portfolio when you are in your 20's or 30's and are 30 or so years from retirement is to spread your investments among mainly equity funds as your portfolio's core; mixing up Large Cap and other growth funds with minimal bond investment and little (if any) money market funds. This will present a more risky investment strategy, but also one that yields more reward over time. The further you are from retirement, the less risky this strategy becomes... so it makes sense to allocate your assets this way if you're young. You'll also want to spread those equity assets to both domestic and international equity funds. This will help reduce risk since the US economy and foreign economies can rise and fall at different rates. As you get older and closer to retirement (lets say you are in your late 40's or mid 50's) you should rebalance your portfolio, gradually increasing your holdings with more bond funds, money market funds, and other assets that are less risky (and consequently have a lower rate of growth) so that you can preserve what you've already earned. This will help protect you from short term market downturns that can potentially ruin what was once a good retirement account.
You may have also heard the term Compounding. Put simply, any interest and dividend you earn per share of your investment assets is re-invested in the account buying you more shares. So over time, your money grows almost exponentially, meaning the earlier you start investing in your retirement account, the better off you'll be down the road. SmartMoney has great tools to help you figure how compounding and the size of your contributions can affect your future retirement account income.
Lastly, there's the issue of Company Stock. Many companies provide this option in their investment plans and may still encourage you to allocate your retirement account in your own company's stock as a way of showing support for the company or showing loyalty. Most people invested their retirement accounts this way in the 70's and 80's with many becoming Millionaires (early workers from Apple, Microsoft, and Intel for example) Even if your company is a powerhouse of a company (Microsoft, etc.) or is considered rock-solid (GE, etc.), this is a really bad idea. Why? I have one word for you... ENRON. This is how many people who worked for Enron lost their shirts. They had invested all or most of their retirement accounts in the company stock. When the corruption scandal exploded, and the big wigs fell.... so did their retirement accounts as well as their jobs leaving them with nothing. It only takes one financial scandal or financial disaster to take down a company. Don't let it take you down with it. The key is Diversify diversify diversify.
For more info, and if you have questions like "What's a Bond?" or "What's a Stock?", be sure to check out Morningstar, Motley Fool and of course CNBC.com (disclaimer: I'm a CNBC employee but this is a non-affiliated blog). They are all exceptional resources for researching your retirement account choices, equities, and mutual/bond funds. Ultimately though, after all the research and advise... the decision will be yours.
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