Photo of the world's coolest retired couple courtesy of Alex Proimos
I mentioned several weeks ago that I will be spending my May semi-hiatus from blogging doing research and writing a book about retirement. I also invited you all to pepper me with retirement questions that you've always been afraid to ask.
I have to tell you, reading your questions produced small animal noises of terror from this researcher/writer. I went into this project with a sense of unwarranted confidence. I know money stuff, I thought to myself as I signed the contract to write AN ENTIRE BOOK. This will be a piece of cake.
Then I read through your questions, and I realized there's a reason why people make a living advising people on how to retire. This stuff is complimicated!
So after a few days spent hiding under a desk emitting high-pitched anxiety noises, I started doing my research. I'm still not feeling like an expert, but I feel much more confident about my ability to know where to find answers. (I'm still waiting for the tax code to make sense to me, particularly vis-a-vis retirement, but I suspect I'll be waiting a long time for that one.)
In any case, I wanted to get started answering your retirement questions today, and I thought I'd start off with the excellent question from maggie.glos:
"As a younger person, I am always confused with whether it is better to
put my retirement money into one of the funds based on my age and how
many years to retirement or if I should be trying to put it into certain
stocks. Which is wiser?"
Part of the reason why this is a tough question to answer is because the answer depends somewhat on you and your personal investing style and risk tolerance. Specifically, if you want to personally play the stock market and you have a high risk tolerance, then you'll be unhappy putting money into a mutual fund based on how far you are from retirement. But if you're somewhat risk averse and a set-it-and-forget-it type of investor (which definitely describes me), then mutual funds will be the way to go.
However, since there are very few people who fit that first descriptor, I'll answer Maggie's question as if she's more like the second type of investor.
One of the reasons why it may seem wiser to pick certain stocks is because of how they have historically performed. But if you visit any financial adviser or read any prospectus, you'll see the words "Past performance is no guarantee of future returns" written somewhere, spoken aloud, embroidered on a pillow, or tattooed on a forehead. Any stock that has gone gangbusters can't promise that it will continue to do so--just ask anyone who invested in dotcoms in 2000 or real estate in 2007.
So, historical performance is not a way to pick a stock. That means you're left with other metrics, like the soundness of the company, the performance of the market as a whole, or your gut, which are equally imperfect methods for choosing a particular stock.
That's why most investors mitigate their risk by buying into mutual funds. These funds diversify the investment by buying into many different securities (securities is a term that includes stocks, bonds, and derivatives)--and mutual funds include professional management of the investments.
Basically, Maggie, it's going to be wiser for 99% of workers to choose a fund rather than pick specific stocks.
However, that doesn't completely answer your question. I was under the impresson that you also weren't sure how to go about choosing funds. This is a common problem, and in fact, it is the stumbling block for many many people and can often be the reason why workers don't buy into their company 401(k). They just can't bear the thought of having to read through all the information and make choices.
Thankfully, it's not as difficult as you might think.
Start by determining your risk tolerance. Bankrate has a "fun" version of the usual risk tolerance quiz that can help you determine how secure you can feel with your money in volatile investments.
Once you know how conservative or aggressive you are, you're ready to start determining which fund is best for you. Look at the investment objectives of your available options. These objectives will be stated clearly in the prospectus for each of your options.
As a young person still decades away from retirement, the best objectives will be growth or capital appreciation (either of these terms might be used). If you are particularly conservative, you might temper those growth assets with more balanced assets. For example, you might choose to put 50% in an S&P 500 Index Fund and 10% in an international stock fund, both of which would provide you with a growth objective, and the remaining 40% in a bond fund that would provide you with more stability. A more aggressive peer might change those rations to 60% S&P, 20% international stock, and 20% bonds. But in either case, a young investor needs to make capital appreciation a priority.
As you get closer to retirement--within ten years, let's say--you'll want to start transitioning from an accumulation mentality to rebalancing. This will be when you start scaling back on the aggressive allocations (which are generally stocks) and amping up your balanced allocations (funds that are a combination of stocks and bonds).
When you reach retirement, you will then want to move into allocations that will produce income in your retirement--things like bonds that offer income objectives.
The third investment objective you'll see is safety/stability of principle. You'll see that on cash equivalents like CDs, T-Bills and money market funds. These will not keep pace with inflation, which means that even though you theoretically can't lose principle with these, you are still losing money in the long run because your principle will be able to buy less and less over the years. Go for stability with money you need to keep liquid, but this is not a real investment strategy.
So, to make a long story short, for most people it is wiser to choose funds based on your age/years to retirement.
Phew. Is anyone else sweating? I feel like I just ran a 5k.
Maggie, I hope this answered your question. For everyone else, please let me know if there is anything you'd like me clarify or if you have any other retirement questions you would like answered. The comment line is open!