Retirement plan decisions made easy
Lesson 4: Investments: How Investments Work
This lesson explains how investments work. If you were satisfied by the answers from Chapter 3, you can skip this lesson. But it’s fun and short, so give it a try if you wish.
Investments generally fall into one of these broad classes:
- Stocks, which are shares of ownership in companies
- Bonds, which are debts
- Mutual funds, which hold many different stocks or bonds
- Money market mutual funds, which hold very short-term debts
Drill Down: Investment Definitions
Your portfolio consists of all the investments you own.
Investment returns show how much gained or lost, usually as a percentage of the amount you started with. Your investment return on a stock consists of the dividends it pays, plus the stocks increase or decrease in value, divided by the starting value of the stock. Over the long run, stocks have earned total returns of about 11 percent per year. Returns on bonds are calculated the same way, but with interest rather than dividends. On average, stocks get most of their returns from price increases, while bonds get most of their returns from interest payments.
Drill Down: Investment Returns
Here are average returns since 1972:
| Asset Class | Return | Risk |
| Treasury Bills | 6.1% | Low |
| Bonds | 8.5% | Moderate |
| Small Cap Stocks | 13.4% | High |
| Large Cap Stocks | 11.4% | High |
| International Stocks | 10.9% | High |
| Real Estate | 14.1% | Moderate |
Drill Down: Returns of Different Types of Assets
Taxes and fees can take a big bite out of your investment returns. Suppose that two people saved equal amounts through their lifetime, invested in exactly the same mutual funds, but one used a 401k, while another invested in a fully taxable account. After a lifetime of saving, the person using the 401k has nearly twice as much net income after taxes. The management fees you pay for your mutual fund or stock advisor also make a difference, but somewhat smaller. The person getting low-priced advice may have over 25 percent more wealth built up over the course of a lifetime. So use tax-sheltered accounts, and watch those expenses.
Drill Down: Taxes, Fees and Investment Returns
Risk is defined a little differently in investments than in everyday life. If you may get something other than what you expect, that’s risk. If your investment earns far more than you expected, you are happy—but you should also realize it could only do that if you took risk. Investment risk reflects upside potential as well as downside potential.
Drill Down: Risk of an Individual Investment
Let’s put risk in practical terms. If you choose an investment that has good expected returns, but also a lot of risk, you’re likely to end up doing well. However, there will be a significant chance that you end up worse off than you started. Translation: the odds that you will have enough money for retirement depend, in part, on how much risk you take.
Drill Down: Risk in Real Life
The first step in reducing the risk of your investments is to diversify. Owning many different stocks, instead of just one stock, reduces your risk without lowering your expected returns. Mutual funds do this for you, which is why they are used in 401k plans.
Drill Down: Risk Reduction: The Free Way
The next step in risk reduction is to blend your investment types. Mixing in some bonds with your stocks is helpful. Surprisingly, if your are a very conservative investor and you own nothing but bonds, you can lower your risk by selling some bonds and buying stocks, up to about 20 percent of your total portfolio. Even though stocks are riskier than bonds, they sometimes move in the opposite direction, so the blended portfolio has less risk than a bonds-only portfolio.
Drill Down: Risk Reduction: The Tradeoff Approach
You have to decide for yourself how much risk to take, but here are some guidelines:
- The younger you are, the more risk you can take
- The sooner you will be spending your money, the less risk you can take
- If you have a great deal of wealth, you do not need to take on much risk
- You should not take on more risk than you can sleep with
- You will be better off financially if you learn to live with a moderate amount of risk
Drill Down: How Much Risk Should You Take?
Here are the basic guidelines you should follow in managing the investments in your 401k:
- Stick with mutual funds; do not buy individual stocks
- Do not invest in your company’s stock (but you can accept stock as a matching contribution)
- Include stock mutual funds in your asset allocation
- Own some international funds, including emerging markets as well as developed countries
Drill Down: Asset Allocation: Bringing It All Together
To get more specific advice, know your tolerance for risk: aggressive, moderate, or cautious. Now consider your age until you’ll start withdrawing funds from your 401k account. Use these two factors to determine what percentage of your portfolio to invest in stocks:
For example, if you’re a cautious person with 30 years until you will need withdraw money from your 401k, then put 70 percent of your portfolio into stocks, which leaves 30 percent for bonds.
Drill Down: Understanding Your Risk Tolerance
Invest your bond money in a short or intermediate bond fund. Short refers to the average maturity, or how long until the bonds are paid off. If your only 401k choice is a long-term bond fund, then split your bond money between the long term fund and a money market mutual fund.
Drill Down: Investing Your Bond Money
Invest your stock money based on the size of the total global stock market:
- Basic Stock Market Allocation:
- 40% U.S.
- 34% S&P 500 (or similar large cap index)
- 6% small cap
- 60% International
- 48% developed countries
- 12% emerging countries
Drill Down: Investing Your Stock Money
If you do not own your own home, you should add real estate to your asset allocation. The best way to do that using your 401k is to buy a REIT fund. (That stands for Real Estate Investment Trust.)
- Stock Market Allocation with Real Estate:
- 36% U.S.
- 18% S&P 500
- 18% small cap
- 36% International
- 18% developed countries
- 18% emerging countries
- 28% Real Estate
Drill Down: Investing If You Do Not Own a Home
I strongly recommend that you not try to time when to buy your stocks and bonds. Pick an asset allocation (either following my suggestions or some other method) and stick with it. People who try to guess when to buy stocks, and when to buy bonds, usually have worse returns than buy-and-hold investors.
Drill Down: Buy and Hold, or Trade?
If you would like to be a little more aggressive in your investments, but still keep risk down to a reasonable level, consider the Ultimate Buy and Hold Strategy, developed by Paul Merriman. With this approach, you start with broad diversification, but then add a little extra to sectors that historically have had higher long-run returns: small stocks, value stocks, and emerging market stocks.
Drill Down: The Ultimate Buy and Hold Strategy
Balanced funds own both stocks and bonds. The are an acceptable choice, but I prefer for you to manage your own asset allocation. Too often, managers of balanced funds will change their stock-bond mix, which can frustrate your efforts to own a well diversified portfolio.
Drill Down: What about Balanced Funds?
Lifestyle funds are set up with your risk preference in mind, so it eliminates one of the steps above. However, they neglect your age, so it’s not a perfect system. Life cycle funds typically adjust to both your risk tolerance and your age. You’ll be happy with a good life cycle fund, or you can follow the guidelines in this course—you should end up in the same position either way.
Drill Down: Lifestyle Funds and Life Cycle Funds
Once a year (or more often if you prefer), recalculate your asset allocation. You’ll probably find that in order to get back to your target percentages, you need to sell some of the funds that have done very well, and buy funds that have not done well. That feels backwards, but it’s what is needed to keep you well diversified. In the long run, you’ll come out much better by rebalancing annually.
Drill Down: Rebalancing
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Lesson 1: What the Heck is a 401k, and What’s So Great About It?
Lesson 2: Contributions to Your 401k
Lesson 3: Investments “Cook Book” Approach
» Lesson 4: Investments: How Investments Work
Lesson 5: Loans and Hardship Withdrawals from Your 401k
Lesson 9: Your 401k, Your Other Assets, and Your Life
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