Once you decide on the best retirement plans for you, start thinking about your investments.
Broadly speaking, retirement portfolios can invest in two asset classes, stocks and bonds. (Both are available individually or as part of mutual funds.) Investments are allocated based on investment goals, performance, and risk tolerance.
Stocks offer investors by far the highest potential return at roughly 10 percent, on average, every year. But stocks also fluctuate: they can dip as well as soar. In fact, some years, such as the 2008-2009 period, see steep declines in the value of stocks. On the whole, the stock market recoups the losses in subsequent years, but the fact is, stocks are volatile – and that’s a potential drawback, especially for investors facing retirement soon.
Bonds are a method of countering the potential volatility of stocks. They provide stability in a portfolio because they are not subject to the same volatility as stocks. Bonds are debt instruments issued by governments or corporations. Bond funds receive, effectively, their interest payments, plus payment at maturity.
But bonds too have a drawback: low returns. Bond yields provide only 2 percent to 3 percent per year, much less than stocks.
Investment Portfolio Allocation
Portfolio allocation is the business of determining the percentage of assets that allow you to benefit from maximum appreciation of your money while protecting you from risk. Portfolio allocation changes over time because the closer you get to retirement, the less chance you’ll have to recover from drops in the stock market.
A handy rule of thumb for portfolio allocation is to subtract your age from 110. The result is the percentage you place in stocks. The amount left is the percentage you place in bonds.
In other words, a 30-year-old would place 80 percent in stocks (because 110 – 30 = 80). The 20 percent left over becomes the bond allocation. But a 65-year-old would invest just 45 percent in stocks (because 110 – 65 = 45), while placing the remaining 55 in bonds.
Bear in mind that rules of thumb, while handy, are not set in stone. People vary in their risk tolerance. While stocks can maximize your returns, you need to assess your own comfort level with their risk potential. Talk to a financial advisor to determine your risk tolerance.
Revisiting and Rebalancing Investment Portfolios
Investors should revisit their portfolios at least once a year for two reasons. First, your portfolio should be adjusted in accordance with your age. Second, your allocation will change as market conditions change.
If stocks rise 25 percent in a year, for example, you will end up with a higher percentage of stocks in the portfolio than your allocation indicates. The process for bringing your funds back into alignment with the allocation is termed “rebalancing.”