If you’re parking money in a savings account, that’s not going to help you prepare for retirement.
Bank accounts, CDs and money market funds may provide safety from loss of principal, but these “cash equivalents” don’t boast the higher returns of other investments.
Consider the following riskier alternatives.
Also called equities, stocks are the cornerstone to most retirement accounts because they’ve boasted higher returns than many other investments, clipping along at an average 10 percent a year since 1926, according to Ibbotson Associates.
That said, stocks come in many different flavors. They represent all industries, with some based in the U.S. and others overseas. Stocks also come in all sizes: There are large-cap, mid-cap and small-cap stocks. The term “cap” is short for “market capitalization,” which is computed by multiplying share price by the number of a company’s outstanding shares.
What does that mean?
“Large-cap stocks tend to be companies that are more established,” says Brett Horowitz, a wealth manager at Evensky & Katz/Foldes Financial Wealth Management. “Small companies tend to have more risk, and the extra risk you’re taking on leads to higher return,” Horowitz adds.
According to Ibbotson Associates, small caps have grown by an average 12 percent annually over the past eight decades. The annual 2 percentage point lead over large caps compensated investors for the extra risk they’d assumed.
When you buy a bond, you’re essentially becoming a lender, since bonds are really nothing more than an IOU that’s been issued by a government or corporation.
In general, bonds are considered safer investments than stocks. But that’s not always true. It depends on the bond you buy. The riskier the bond — that is, the lower a borrower’s credit quality or “rating” — the higher the interest rate and the more you stand to gain, unless, of course, the borrower defaults. Firms such as Standard & Poor’s and Moody’s are among agencies that determine whether bonds are “junk” status, meaning they carry high risk, or “investment grade,” meaning they carry little to moderate risk.
U.S. government bonds are guaranteed by Uncle Sam, so they’re the safest around. They mature — or come due — in various time periods. Treasury bills generally mature in three months while Treasury notes typically mature within a year. Treasury bonds mature over longer time frames, usually between five and 30 years. Historically, long-term government bonds have returned an average of 5.5 percent annually, according to Ibbotson Associates.
Local and state governments also issue bonds. Not all are guaranteed, but they’re considered relatively safe investments, depending on a government’s creditworthiness. That said, municipal bonds have a distinct advantage: Income is generally exempt from federal taxes and sometimes free from state taxes, too.
The usual suspects
- Losing principal. What you invest in goes belly up and you lose a lot or everything. Culprits: individual stocks and high yield bonds.
- Not keeping up with inflation. Prices go up faster than your investments, eroding your spending power. Culprits: Treasury and municipal bonds and cash equivalents.
- Falling short. The investments you choose don’t generate enough growth for you to meet retirement goals. Culprits: Treasury and municipal bonds and cash equivalents.
- Paying high expenses. Investment costs make it difficult for fund managers to beat their benchmarks. Culprits: Certain mutual funds, especially those that are actively managed as well as those that have sales loads.
Think of these as baskets that may contain bonds, stocks and cash equivalents. With thousands to choose from, mutual funds come in a variety of styles. They may hold a single type of asset, such as only domestic large-cap stocks, or a blend of investments, such as a balanced fund with a mix of stocks and bonds.
Mutual funds also come in a variety of styles. Some are more risky, others less so, depending on what they’re invested in. Index funds are geared to mimic certain indexes (such as the Standard & Poor’s 500) and they tend to be more tax-efficient and less costly than, say, managed funds, which also may have sales charges and other expenses.
Mutual funds enable investors to buy a multitude of assets relatively cheaply. Instead of spending $1,000 for shares of a single company, you could spend the same amount on a fund that holds the same company plus many others. That’s a cheap way to diversify your assets and hedge against risk.
Finally, mutual fund companies are generally run by managers who pay close attention to how assets are performing. If you don’t have the time or expertise to monitor various investments, then putting money into a mutual fund can be a safer, more practical way to invest.