Breaking it down
Investments, whether in or outside a 401(k) plan, can be divided into three categories: stocks, bonds, and cash and cash equivalents.
- Stocks represent an ownership interest in a company, so when you invest in a stock fund, you’re investing in shares of several companies.
- Bonds are investments issued by governments and corporations when they want to raise money. When you invest in a bond, you’re giving the bond issuer a loan, which they agree to pay back over a defined period of time, with interest.
- Cash and cash equivalents include investments that can be easily liquidated, like money market funds, which invest in short-term, low-risk bonds, and cash and cash equivalents.
Stable value funds, a hybrid security only available in your 401(k), are alternative investments with a similar objective to money market funds. While it may be difficult to understand all the nuances of the investment, the bottom line is that it is a capital preservation investment vehicle. While no losses have been experienced industrywide, when investing in these funds, you should expect to withdraw the amount that you contributed plus interest, which is added to your account on a daily basis.
You can invest by buying individual securities or a fund. While the ownership structure for mutual funds and collective investment funds (typically found in 401(k) plans) are different, the end result is the same: Each invests in a pool of securities with similar characteristics. For example, there are funds that invest strictly in small company stocks or in government bonds.
Investing in individual securities is riskier than investing in a fund. Because a fund invests in many securities, the manager of the fund is not reliant on picking the right “one” security or a small handful of securities to generate your return. Many funds have hundreds of securities, so the manager of the fund doesn’t have to get it right 100% of the time for you to get a good return.
Risk and return
Risk and return go hand in hand. The riskier your investments, the more return that you should expect. So stocks are riskier than bonds, which are riskier than cash equivalents. The question becomes: How much risk are you willing to take? Your investment risk profile is dictated by a number of factors: How long until you retire? How much have you saved? Are you willing to give up some return to lower the risk of loss in your accounts? How much of your account are you willing to lose in the short term to midterm?
The acceptable level of risk for your investment portfolio is based on your answers to these and other questions regarding your specific financial situation. There is not one right answer that would satisfy each investor’s retirement goal.
For example, if you have many years until retirement, you have a longer period of time to recover from losses that you experience in your accounts, and therefore, you may feel more comfortable taking on more risk, like investing more in stocks to generate your return over the long term. While stock prices are more volatile, historically investments in stocks have been shown to generate higher returns than some other investments.
As your retirement approaches, again, depending on your circumstances, you may wish to reduce the risk associated with your investments because the time to recover your losses shrinks. For example, you may decrease your investments in stocks and increase your investments in bonds and maybe even cash equivalents.
Retirement goals
Behavioral studies have shown that when the stock markets experience a downturn, some investors get jittery, sell their stocks and invest their proceeds in money market funds. This behavior typically leads to returns that are less favorable than continuing to hold the investments. Experienced professionals have many tools and models to predict the up and down markets. They aren’t always successful.
The chart below, a J.P. Morgan Asset Management analysis using data from Bloomberg, illustrates that historically investing for the long term generates better results.
