When saving for retirement, some investors appreciate the “do it yourself” flexibility of choosing their own investments; while many others prefer the “do it for me” approach, choosing to have their investment portfolio professionally managed through target date funds or risk-based portfolios. No matter which approach is right for you, it’s important to understand three fundamental concepts of retirement plan investing.
Choosing your investment mix, or asset allocation, is one of the most critical steps to take when saving for retirement. In fact, your asset allocation choices may be responsible for over 90 percent of your portfolio’s performance.1 As you select investments for your retirement savings portfolio, you will have access to different types or classes of investments. These three types of asset classes are typically found in retirement plans:
- Stock (Equity) Funds – These funds hold shares, or part ownership, in companies. Historically, stock funds have offered the greatest potential for delivering the highest returns over the long-run. However, they are also considered the riskiest types of investments because their value tends to go up and down more than other fund types.
- Bond (Fixed Income) Funds – These funds invest in corporate or government debt that pays interest. Bond funds historically deliver lower returns than stock funds, but they are considered less risky because they tend to not fluctuate in value as much as stocks.
- Stable Value Instruments – These investments include cash and short-term instruments that are even less risky than bond funds and tend to protect the value of the original investment rather than seek growth.
Within each asset class, funds have different investment objectives. These often correspond to specific characteristics including investment styles (such as value or growth), market capitalization (such as large-, mid- or small-cap), geographic region (such as U.S., international, or emerging market), or bond duration (short-, intermediate-, or long-term).
An important factor in your asset allocation decision is your time horizon, or how long you have until you retire. Experts recommend that the longer your time horizon, the more you should consider allocating to stocks. That’s because if your retirement is many years away, you can afford to weather some ups and downs in the short term for the benefit of more significant potential gains over the long term. As your time horizon shortens, you have less time to recover from a large loss in your investments; so you may want to consider allocating less to stock funds, and more to conservative investments, like bond funds and stable value funds.
Spreading your retirement savings across different types of funds, known as diversification, can help reduce the likelihood of major losses because different investment types will move in and out of favor at different points in time.
Investment diversification can (and should) take place at many levels. You can invest in different asset classes to help reduce risk, and within asset classes, you can invest in various investment styles. You should also evaluate the level of diversification within the investment alternatives you are considering. For example, some fund managers concentrate a fund’s underlying investments in a relatively small number of companies because it fits the fund’s investment style or objective. Other funds are more diversified because they invest smaller proportions of the fund’s assets in a larger number of companies.
Once you determine which funds are the best fit for your retirement savings and how much you want to allocate to each fund, you should set a schedule to check on your investments. To maintain your strategy, you may need to periodically adjust how much of your account is invested in each of the investments you picked because different investments in your portfolio will grow at different rates.
Over time, some investments may grow at a faster rate than other investments and could represent an ever-larger portion of your portfolio than originally intended. You may need to periodically rebalance, or reduce, the amount of your retirement savings that is allocated to the overperforming investment and allocate more to other asset classes. In this way, you are putting into practice the “buy low, sell high” principle of investing. You are also making sure that your original asset mix is maintained.
You do not need to rebalance too often. You may want to review your account on a quarterly basis and only rebalance if the allocation is significantly different than your desired strategy. Your employer may also have an automatic rebalancing feature that you can use to do this for you annually.
Consider the big picture
Although it can be nerve-wracking to watch your savings rise and fall in value, some investment risk is good because you’ll need the growth in value to help outpace inflation. So do-it-yourself investors should keep the diversification principle in mind, understand the sources of their investment risk, be comfortable with the amount of risk they’re taking—and have the patience to ride out the ups and downs. There are tools available to help you allocate, diversify and rebalance your account.
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Asset Allocation and Diversification don’t protect against loss or ensure a profit, but can be solid investment strategies.
1 Financial Analysts Journal, “Determinants of Portfolio Performance,” May/June 1991.