The types of assets in which your savings are invested will significantly impact your return on investments and, consequently, the amount available to finance your retirement. As a result, a primary object of investment portfolio managers is to create a portfolio that is designed to provide an opportunity to experience the highest return possible.
Amounts that you have saved for short-term goals are usually kept in cash or cash equivalents, because the primary objective is usually to preserve principal and maintain a high level of liquidity. Amounts that you are saving to meet long-term goals, including retirement, are usually invested in assets that provide an opportunity for growth.
If you manage your investments instead of using the services of a professional, it is important to understand that there are other factors to consider. The following are just a few:
The investments that provide the opportunity for the highest rate of return are usually the ones with the highest level of risk, such as stocks. The ones that provide the lowest rate of returns are usually the ones with the least amount of market risk.
Your ability to handle market losses should be factored in when designing your investment portfolio. If the amount of market risk associated with your portfolio causes you undue stress, it may be practical to redesign your portfolio to one with less risk, even if it is determined that the amount of risk is suitable for your investment profile. In some cases, it may be practical to ignore a low level of risk tolerance if it is determined that it negatively impacts the ability to provide for sufficient growth for your investments.
Generally, the level of discomfort one experiences with risk is determined by one's level of experience and knowledge about investments. As such, it is in your best interest to, at a minimum, learn about the different investment options, their market risks,and historical performance. Having a reasonable understanding of how investments work will allow you to set reasonable expectations for your return on investments, and help to reduce stress that can be caused if expected returns on investments are not achieved.
Your targeted retirement age is usually taken into consideration. This is usually used to determine how much time you have to regain any market losses. Because you are in your twenties, it is presumed that investing a large percentage of your savings in stocks and similar assets is suitable, as your investments will likely have sufficient time to recover from any market losses.
Types of Investments and Availability
The type of assets in which you can invest your savings may depend on the type of account in which they are held. For example, if your savings are in a 403(b) account, your investment options are limited to mutual funds or annuities.
For defined contribution plans, your employer determines your investment options. Some choose and manage the investment themselves, some provide a definitive list of assets that you must choose from when designing your portfolio, and others allow self-direction which means you can choose to invest in any stocks, bonds, mutual funds and other available assets.
For defined-benefit plans, the investments are chosen and managed by the plan. For IRAs and regular savings, you can invest in any type of asset, as long as they are available through the financial institution with which the IRA is held. If the IRA is held with the traditional side of a bank, your options may be limited to certificate of deposits and money market funds. If the IRA is held with the brokerage arm of a bank or a brokerage firm, you may be able to self-direct your investments into stocks, bonds and other publicly-traded assets, as well as some non-publicly traded assets. A mutual fund company may limit your investments to mutual funds.
The following are some of the investments in which you can place your savings:
Stocks: Stocks represent ownership in a company, and the rate of return is usually dependent on how well the company performs. For instance, if you own 100 shares of Microsoft, you then have ownership in Microsoft and your return on your investments is determined by how well Microsoft performs.
Historically speaking, stocks provide a higher return on investments than other investments.
There are several types of stocks in which you can invest, which include:
- Blue chip stocks: These are stocks of recognizable companies with a long history of positive market performance. Examples include Microsoft, McDonalds and Wal-Mart.
- Income stocks: These are stocks that usually pay out high dividends, and are usually recommend for individuals who have a current need for income from their savings. Income stocks are usually not recommended for someone in their twenties.
- Growth Stocks: These are stocks of companies that are expected to increase in market value and unlike income stocks, which usually pay dividends, growth stocks usually reinvest dividends helping to increase the value of the stock.
- Value stocks: These are usually considered to be undervalued, and therefore available at bargain prices. The expectation is that they would produce significant return on investments when their market price is corrected.
- International stocks: These are stocks of companies in foreign countries.
Bonds: A bond represents a loan to the issuer, who is often the federal government, state or local government, or corporations. Typically, investments in a bond guarantees a return on investment with interest being paid at agreed pre-determined time frames and the principal amount being returned when the bond matures. The following are some of the types of bonds in which you can invest:
Municipal bonds: These are issued by state and local governments, and produce tax-free income. Because of the tax-free nature of these bonds, they are usually not considered a suitable investment for tax-deferred accounts, as distributions from these accounts are treated as ordinary taxable income. As such, investing your tax-deferred amount in a municipal bond could result in you paying income tax on amounts that could have been tax-free.
Treasury bonds: These are backed by the credit of the United States and issued for 30-year terms. They pay interest every six months until maturity, at which point you would receive a payment for the face value. The interest is exempt from state and local income taxes.
Treasury notes: These issued for terms of2, 3, 5, 7 and 10 years, and pay interest every six months until maturity, at which point you would receive a payment for the face value. The interest is exempt from state and local income taxes.
Zero Coupon Bonds: These do not pay interest, but are sold at a discount rate.
Bonds are considered a safer investment than stocks, but stocks usually provide higher returns over the long term. It may make better financial sense to invest non-tax deferred assets in bonds that provide tax-free interest, as investing tax-deferred amounts in these bonds would result in the interest being taxable.
Mutual Funds: Mutual funds allow you to invest in multiple securities or binds[E1] by making one purchase. For instance, you may find that one fund has invested in hundreds of stocks. This may allow you to diversify your portfolio more easily. Mutual funds are usually managed by expert money managers, which means they allow you to get the benefit of a professional investment advisor, albeit indirectly.
When investing in a mutual fund, you have the option of choosing between growth funds which, as the name suggests, provide for growth or income funds, which provide income.
Cash: Cash and cash equivalents are usually recommend for long-term savings[E2] . However some professionals do recommend investing even a small portion in your savings to hedge against market volatility. These include:
Certificate of deposits: These provide a guaranteed rate of return, and the interest rate is usually higher for amounts that are larger or deposited over longer periods. Usually, you are required to choose the deposit period at the time the certificate of deposit is established, and if it is terminated early, the financial institution may assess an early withdrawal penalty. These are usually available to IRAs, but are not usually offered for qualified plan investments.
Money market mutual funds: The features and benefits of money market mutual funds depend on the type of asset in which the amount is invested. For instance, tax-exempt mutual funds are invested in state and local government securities over short periods.
Cash and cash equivalents can also be used to temporarily hold funds that you may need to invest in other assets as needed. There are many other investment options available, and what is included in your portfolio is usually determined by what your portfolio manager thinks is suitable. For example, while many consider annuities a good investment for those who want to preserve principal and guaranteed return on investments, they are usually more suitable for individuals who have amassed enough to make it worthwhile, and individuals who are closer to retirement age.
When designing your portfolio, your advisor will take many factors into consideration, such as:
- Whether there is sufficient diversification. This helps to hedge against market losses, by using different types of investments and different asset classes.
- Whether and how often your portfolio needs to be rebalanced. What worked for you a year ago might not be practical now.
- Your other savings and how they correlate with the amounts being invested.
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