‘Your Financial Future:’ Assessing investment risk is critical for your retirement plan
This is the second installment of a three-part series on retirement planning.
This week we continue our discussion of self-funded retirement. Past generations enjoyed defined benefit plans – when their employer promised a certain benefit to retired workers. The company contributed all of the funds and bore the investment risk.
Today, most plans have switched to defined contribution plans. A 401(k) is one example: Employees defer some of their current income and deposit it into a 401(k) account. Often the company will provide a match up to a certain percentage of the employee’s contribution.
The employee selects the investment option from a menu that usually includes different mutual funds and usually a fixed-interest option. The process of asset allocation, which is selecting from the different investment choices, will have a huge effect the amount of money on with which you’ll enjoy retirement. If the assets grow significantly, you may be able to travel and do many activities. If your retirement account performs poorly, retirement could be a struggle.
When people invest in the stock market with nonqualified funds, they must fill out a risk tolerance form to determine their comfort level with risk. Normally, you do not do a risk tolerance for a 401(k), but you still must take this into consideration. When investing, we expect to have the possibility to receive more return on our investments if we take more risk.
Investing in growth stocks will have a lot more volatility than investing in the fixed accounts. This volatility can bring much bigger gains, but also can produce much bigger losses. You never want to take more risk than you can handle. If your investments are causing you to lose sleep at night, you probably need to reduce some risk. How much time you have until you reach retirement is an important consideration when allocating assets.
If you have a long period of time you can probably assume more risk. As you get within a couple of years of needing the money, you must get more conservative with your investments. If you don’t, you could experience sequential risk. This means if you need to start withdrawing money from your account when the stock market is in a correction, it could destroy your retirement. We will discuss this further in a future column.
There is kind of a paradox here. If you do not have many funds, you may need to take more risk to try and grow your assets. However, you cannot afford to lose limited assets. This is a dilemma of investing. To make wise choices, many people must expand their financial knowledge. That is one of the goals of this column.
When you consider your asset allocation, you must understand what makes up these investments. The mutual funds are composed of a group of stocks and bonds. Stocks are ownership in a company while bonds are debt instruments. When you buy a bond, you are lending money to the corporation for a certain period of time. For the use of your money, the company pays you interest.
The stock market is the biggest auction in the world. I often ask people a basic question about stocks that most answer incorrectly. If you buy $100 of Ace Corp., how much of your money does Ace get? Many people answer all to 95 percent. When I tell them that Ace gets zero of their money, they are surprised. The person who actually gets the money is the stockholder who is selling $100 of Ace. You are buying because you think the value will go up. They may be selling because they think the price is going down. They also could be selling because they need to generate cash for a new roof or some other purchase. When a stock is first issued in an initial public offering Ace gets the majority of the money. Most trades are done on the secondary market.
When more people want to buy stocks than sell, the market goes up. When more people want to sell than buy, the prices go down. That is the most basic factor about direction of the market. We will look at values in a further column and things you need to know to enhance your retirement.
In our next column, we will discuss how much you need to save to have the retirement of your dreams.
Gary Boatman is a Monessen-based certified financial planner. He is the author of “Your Financial Compass: Safe passage through the turbulent waters of taxes, income planning and market volatility.”
To submit columns on financial planning or investing, contact business editor Michael Bradwell at mbradwell@observer-reporter.com