What is an investment?
In finance, an investment is a monetary asset purchased with the expectation that the asset will provide income in the future or appreciate and be sold at a higher price.
This is different from “speculating” or “gambling” in that it is not chasing the “big, fast return” and involves a thorough analysis. The goal of retirement investing is to build sufficient wealth to allow you to withdraw sufficient money to retire on without depleting that wealth, or at a minimum not completely deplete it while you are alive. What dollar amount that would equate to varies depending upon the individual situation but a number of online calculators are available to help you estimate what will be needed.
Every investment fund is different. They will have different goals and thus different investment portfolios. As the number of funds you have to choose from increases you will find that your investment options increase accordingly. Employee sponsored plans generally have limited fund availability but can be supplemented with a personal investment through a brokerage which can provide access to thousands of investment funds.
Risk is correlated with return (or performance) when talking about investments. Lower risk investments are “safer” and can provide a “guaranteed” rate of return. However, the lower risk investments provide lower rates of return while the higher risk investments can provide higher rates of return. All investments have the possibility to lose money, but they can also help to build wealth.
Your personal risk tolerance will be impacted based on a number of factors including your age, investment objectives, personal financial conditions, as well as your personality.
Each type of investment carries a different level of risk. The following two charts show a generic overview of some types of investments and their relative risk versus potential returns.
(Note: Click on images to view larger version)
This is a fundamental question that has to be answered in order to properly manage risk and plan your investments so that your investment goals are achievable. The Investment Horizon is the time period until you anticipate needing that investment (i.e. time until retirement).
The longer your investment horizon, the more risk you can afford to take on in your investment portfolio. This is because any significant drop in value (from negative investment returns) has more time to be overcome and still allow you to reach your goals. This also allows you to capture the “higher returns” from those higher risk investments so that you can grow your investments faster. Doing this allows you to reduce your risk (and thus expected return) as you get closer to retirement so that you can protect the wealth you generate over the years.
The Power of Compounding:
Compounding is the term which describes how your money grows and the use of that growth to reinvest. The more time you have to take advantage of compounding, the less you must contribute to achieve the same goal with the same portfolio. The following chart shows two scenarios, both of which have 10% annual returns (for illustrative purposes only). “Person A” started investing 10 years ago and put $40,000 in investments over 4 years. “Person B” put $60,000 in investments over 6 years. However, since Person A started 4 years earlier the power of compounding results in her having more money in her investments despite putting in only 2/3rds as much of her own money when compared to Person B.
Taxation is important for a couple reasons.
First, there are “tax advantaged” investment accounts as well as investment accounts that have no tax advantages. For retirement investing, it is pretty much always best to use tax advantaged accounts (especially if they include company matching of investments). There are limits on how much can be deposited into these accounts but up to that limit the contributions provide for significant benefits.
Second, your taxable income will determine which type of tax advantaged account is more suitable for your situation (i.e. will produce the most income in retirement). A general rule of thumb is that, with the assumptions that the tax brackets won’t change significantly in the future and your tax bracket will be lower in retirement than while working, a ROTH (401k or IRA) account is more suitable for an individual with an adjusted gross income (AGI) under $75k/year or a married couple with an AGI under $150k/year. Above those levels, it’s generally better to go with a traditional account. That is just a general guideline however. There are a number of places on the internet which will let you input your specific situation with more details and help you compare the results of the two.
Diversification is the finance world’s way of saying “don’t put all your eggs in one basket. Diversification involves three main categories: Asset Class, Market Capitalization, and Industry. Failure to diversify can result in a single investment or investment type having a significant impact on your investment portfolio. See the following chart for a visual representation of how diversification can protect your portfolio:
Asset Class refers to what the “type” of investment. These categories include Foreign Stocks, U.S stocks, Bonds, and Cash or Cash Equivalents. These have various levels of risk (as discussed above) with Foreign Stocks having the highest risk, then U.S. Stocks with less risk, then Bonds, and finally Cash with the lowest investment risk.
Market Capitalization (or “sub-asset class):
Market Capitalization refers to the value of the company’s total outstanding shares (i.e. the stock price times the total number of shares outstanding). Companies are then placed in groups: Mega cap, large cap, small cap, micro cap, and nano cap. Micro cap and nano cap typically refer to “penny stocks” or stocks not traded on the major exchanges and have exceptionally high risk for the potential for return. For that reason I do not generally include them in investments and leave those companies for speculation, not investing.
The risk, and associated return potential, increases as the market capitalization becomes smaller across different investments. This means that small cap stocks provide higher risk and higher potential return while the large cap and mega cap stocks provide lower risk but generally lower potential return as well. This means that diversifying across the different asset classes.
Companies are generally broken into 11 different industries:
Basic materials, Consumer Cyclical, Financial Services, Real Estate, Communication Services, Energy, Industrials, Technology, Consumer Defensive, Healthcare, and Utilities.
Since entire industries are sometimes subject to significant gains, or significant losses, it is important to diversify across industries as well. This allows your investment portfolio to benefit from surges in a given industry while softening the blow from any single industry’s losses. This diversification provides the same type of protection as illustrated previously regarding stock diversification. My general rule of thumb is to not allow any given industry to be more than 15-20% of an investment portfolio.
There are a number of ways to choose your retirement investments and they start very simple and get more complex.
The simplest way is to invest in a target date retirement fund (or TDR fund). This is a fund that will automatically adjust the risk level of the investment portfolio based on time until retirement. However, these funds do not take into account any possible factor besides your investment horizon. A person starting to save for retirement at age 40 will have the same portfolio in one of these funds as a 40 year old who already has three times their annual salary in retirement savings/investments. If they both have the same goal then the person just starting to save will have to invest significantly more to reach that goal.
Slightly more complicated, but still relatively painless, is to talk with a financial advisor who can determine your situation and goals. They can then tell you what to invest in or manage your investments for you. This can be a free service (if included in your company plan for instance) or can be something you pay them for. Be aware, however, that some financial planners may steer to toward investments that are not necessarily the “best” choice for you if they get something for having people invest a certain way or in certain funds. If possible, ensure your financial advisor is paid only for their advice and not for selling products to you.
Even more complicated, but still not entirely “daunting”, is to choose your investments by yourself. When doing this I recommend that anyone without significant time, as well as a significant education regarding finance, stick to only investing in funds (whether they be mutual funds or exchange traded funds (ETFs) and that they not try to “pick stocks”. Picking stocks instead of investing in funds reduces the diversification of your investment portfolio. As such, I feel that “picking stocks” should be left to those who have the time and education to understand exactly how to do that (something I will not be covering here).
For this method, the first step is to discover what “type” of investment portfolio fits your needs. There are 4 “main” types of investment portfolios: Income, Income and Growth, Growth, and Aggressive Growth. I’ve put together some basic examples of each in this post: http://jlcnuke.wordpress.com/retirement-investment-portfolio-types/
Fund Fees (these do matter!):
Higher fee funds (such as actively managed funds) are not necessarily going to outperform (in fact most don’t) passively managed index funds. However, if you invest $100,000 today and your fund fees are 0.3% higher than my same investment then, over 30 years, my investment (assuming the same portfolio) would be expected to be over $80,000 higher than yours due to the fees and the lost “opportunity cost” (i.e. those fees disappear and thus don’t get invested and get compounded).
If you’re afraid you can’t afford to invest, or think you can’t, you may benefit from reading this page as well http://jlcnuke.wordpress.com/financial-and-life-advice-for-the-young-and-maybe-the-older-as-well/