While current obligations and financial emergencies may make it hard to prioritize savings at certain points in our lives, many people put off saving for retirement (or any other need) not because they cannot afford it, but because they are overwhelmed with the options and terminology. Putting off saving can have compounding effects, not only because it’s easy for days to become weeks, then years and even decades, but because the effects of reinvested earnings mean that, by retirement age, a dollar invested at age 25 will grow more than one invested at 35 and far more than one invested at 45 or 55.
Once you’ve begun saving, the options for how to invest that money can be overwhelming. While nobody can predict future returns, this article goes over the basics of some guidelines for understanding the vocabulary and choosing what types of investments to make with your retirement plan and other savings accounts.
When you buy a stock, you are buying a small share of ownership in a company. The price of that share is determined by market forces – more people wanting to buy shares of that company than sell them will raise the price whereas fewer buyers and many sellers will lower it. In the long run, if a company does well, the demand for ownership of that company would be expected to increase and the stock value to rise. A company that is struggling will generally see its stock price decline. If the company fails and has no underlying assets, the stockholder owns a piece of nothing and the stock becomes worthless. Since companies can and do fail, holding individual stocks can be very risky. If an investor has enough invested to diversify, or spread his or her risk among several different companies, different industries, different size stocks and different types of stocks, risks can potentially be reduced. Although it can reduce the risk to your portfolio of a catastrophic loss, diversification alone does not guarantee a profit or protect against the possibility of loss.
A bond, in contrast, is a unit of debt rather than ownership. When a company issues bonds, they are taking out a loan from investors, with a promise to make regular interest payments for the term of the loan and to pay out the amount borrowed in full at the conclusion of the loan term. As with other types of loans, the company has a contractual obligation to pay this money back. The value of the bond may fluctuate on the open market, but even when the value declines, companies are still required to make interest payments. While issuers (especially high-yield or “junk bond” issuers) do sometimes default, or fail to make interest payments to bondholders, a company would need to be insolvent and in the bankruptcy process to be legally allowed to stop paying. Even then, bondholders’ claims against assets are above those of stockholders’ and they can be more likely to recover some of their principal during the bankruptcy process. The principal value of bonds may fluctuate with market conditions. Bonds redeemed prior to maturity may be worth more or less than their original cost. Bonds are subject to inflation risk (the risk that inflation will make each fixed payment worth less over time), interest-rate risk (the risk that market interest rates will rise above the rate on existing bonds), and credit risks (which includes the risk that the individual issuer will not be able to pay). Due to interest rate risk, as interest rates rise, bond prices typically fall, which can adversely affect a bond fund's performance.
For those who are not wealthy enough to own many individual stocks and bonds without incurring very high trading costs, mutual funds and electronically traded funds (also known as ETFs) offer a way to buy a portion of a portfolio that holds the stock and/or bonds of many different companies. By buying a share of a mutual fund, you own a small amount of each investment the fund owns in the same proportion that the fund itself owns them.
Mutual funds are not guaranteed or insured by any bank or government agency--even mutual funds sold by banks. Before investing in a mutual fund, carefully consider its investment objectives, risks, fees, and expenses, which are included in the prospectus available from the fund. Read it carefully before investing. The return and principal value of a mutual fund fluctuates with changes in market conditions. Shares when sold may be worth more or less than their original cost.
Most funds specialize in a specific type of investment, or asset class. Generally stocks are broken down into asset classes based on the company’s size (large, mid, or small “cap” or capitalization) or region (such as US, international, or emerging markets). Some funds may have more targeted objectives, focusing on a particular industry or a single foreign country. Bonds funds are usually specified by their term (when the principal payment is due) and their sensitivity to changes in the interest rate (also called “duration”). There are also bond funds that focus on high-yield bonds (which have a higher interest rate and a higher risk of default), international bonds, and other more specialized categories.
For individual investors, the major difference between mutual funds and ETFs is that mutual funds are generally open-ended, meaning that shares are either issued or redeemed by the fund itself. The fund prices the underlying assets at the close of the market each day, and any orders to buy or sell entered during the market day are executed by the fund itself. ETFs, on the other hand, are purchased from and sold to other investors on a stock exchange, like an individual stock. They require opening an account, such as a brokerage account, that can hold the shares, and can incur trading costs and commissions. Once purchased, their underlying expenses are sometimes (but not always) less than those of mutual funds. They may also be more tax-efficient, for investors who are not holding the fund within an IRA, 401(k), or other tax-deferred account. As with a mutual fund, before investing in an ETF, carefully consider its investment objectives, risks, fees, and expenses, which can be found in the prospectus available from the fund. Read it carefully before investing.
Another category of investing that you may see talked about in the news is active vs. passive investment. Active investments are those in which a professional fund manager (or team of managers) researches investment opportunities in the market and economy as a whole and makes decisions about which individual stocks and bonds to buy. The goal of active management is to perform better than the market as a whole, which is usually measured by one or more indices. An index, like the S&P 500, is a set of stocks or bonds designed to represent overall performance of a section of the stock (or bond) market. Recently, “passive investing” which merely tries to mimic the performance of an index rather than outperform it, has grown rapidly. Unlike actively managed funds, passive mutual funds and ETFs attempt to match the overall results of the market or sector they are tracking. While their investors are giving up the potential upside of better than average market returns, without the expense of research and active management, passive management fees can be lower.
While there is no way to know today what type of investment will do best next month or next year or even in the next 3-5 years, investments that are riskier (such as stocks) have generally outperformed more conservative investments (such as cash) over long periods of time. Over short periods of time, however, aggressive investments like stocks can be subject to drastic fluctuations. If you have savings that you expect to use within a short period of time, such as emergency savings or a fund for a home purchase or upcoming vacation, the priority is keeping that money stable in the short term. For those types of savings, the reduced risk is generally worth the lower return of cash and other short-term investments (such as money market funds and CDs).
Retirement, however, is a very long term goal. Even for those who are only a few years out from retirement, those funds will likely need to last into their 80’s or even 90’s rather than all being spent the day they stop working. For those who are just getting started and may be in the workforce for 20, 30, or even 40 years before even beginning to withdraw funds, there is a lot of time to ride out the ups and downs in the market.
The greatest risk is not that one’s investments will drop at some point in the future. In fact, for more aggressive portfolios, a down market and a drop in account value is virtually certain to happen at one point or another. With a long time horizon, however, investments will not need to be liquidated while their value is down. Although it may be tempting to sell and avoid any further decline, it is selling into a down market that locks in the losses that occurred. By keeping money that will be needed in the short term out of more aggressive investments, you can insulate your portfolio against being forced to sell while markets are down.
The other way investors end up selling at a low price is by investing beyond their risk tolerance, and feeling that they have no choice but to sell and move their savings to cash following a decline. While a knowledgeable and experienced advisor can be a resource to help remind you of the importance of staying invested and focusing on long term goals, for many investors there comes a point where portfolio declines become psychologically very difficult to endure. In order to avoid ending up in this situation, it is important to think about the downside as well as the upside when investing. For someone who will be unable to sleep at night and need to move their funds to cash after even a 5% loss, an aggressive portfolio may not be appropriate even if investing in funds with a very good recent track record. While taking more risk can make it easier to reach long term goals, a financial planner can help those with a more conservative risk tolerance strategize if and how they can pursue those goals with less opportunity for growth in their portfolios.
Once you have determined how much risk you are comfortable taking and will need to take to potentially meet each future goal, being properly diversified can help to reduce the amount of unnecessary risk in your portfolio. While the higher risk inherent in stocks as compared to bonds and cash has been rewarded with higher long term returns over most multi-year periods of time, the risk of being concentrated in one stock or type of stock does not often yield the same long term benefit. Likewise, being diversified among different types of stocks and bonds can help increase your returns. In the mid-2000’s, the returns of emerging market stocks provided the highest return among all major asset classes for five years in a row. In 2013-2015, however, emerging markets suffered among the largest losses of all. As no one knows the future, no one knows what next year’s “hot” and “cold” asset classes will be. But we do know that over time, owning multiple asset classes, particularly those which are less likely to correlate (or move in the same direction at the same time) can smooth out your portfolio returns and assist you in meeting your goals.
Remember that the objective is not the highest returns possible. The true purpose of setting aside and investing a portion of your earnings is to reach your goals. Your investment account is not an end in and of itself. It is a tool to help you reach your goals, whether to stay afloat after a job loss, to pay for a child’s education, or to be able to retire on your terms. Saving should be targeted to meet your goals and your risk tolerance, even if that means sacrificing the potential for larger returns or riding out volatile markets in the short term to further your long term objectives.
Robin Starr is a registered representative of Lincoln Financial Advisors Corp. Branch address 1510 Fashion Island Blvd, Ste 210 San Mateo, CA. Branch phone number 650-377-4108.
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