Most people know they need to save around 10% to 15% of their income throughout their working life to have enough money to retire. But simply putting this money into a 401(k) or IRA isn't going to cut it - you need to make sure you're doing the right things with your retirement contributions. And for most people, that means investing some of the money in the stock market.
Investing part of your retirement money in equities doesn't have to be hard. And if you make smart choices about what you invest in, your contributed funds will work for you over time to help your nest egg grow.
Why you need to invest your retirement account money
Depending on what kind of retirement account you're using, your contributions will often sit in the account in cash until you make a decision about what investments to buy. Although some brokerages pay a small amount of interest, the return on your funds will be negligible until you invest.
You may have only a narrow range of choices for what to do with your money if it's in a workplace plan, such as a 401(k), or you may be able to invest in almost anything you want if it's in an IRA at a brokerage account. No matter the type of account, though, you should have the ability to get some of your money into the stock market.
And you should take advantage of that chance since buying equities has consistently proved to offer the best balance between the level of risk you're taking on and the potential returns you can earn.
Investing in the stock market undoubtedly carries a bigger risk of losing money than if you kept your funds in cash or bought bonds. But you can expect to earn around a 7% average annual return over time if you invest in index funds that mirror the performance of a market as a whole, such as an S&P 500 index fund. Or you could perhaps earn much more (or much less) by buying individual stocks.
As your invested money grows, the returns you earn can be reinvested and start earning money for you. When this happens and you earn interest on interest, it's called compounding, which is the fastest and best way to grow your wealth. In fact, because of compounding interest and the returns you can likely earn by investing in equities, you can hit big retirement savings goals even with relatively small contributions.
To see the effects of this, the chart below shows the approximate amount you'd need to contribute to your retirement account each year to have $1 million saved by 65 if you start saving at 30 and earn differing rates of return.
|2% Return||5% Return||7% Return||10% Return|
It's really hard, and perhaps even impossible, to get up to those 5%, 7%, or 10% returns without putting some of your money into stocks. So if you want to have the money you need as a retiree, you're going to have to buy some equities or save upward of $11,000 a year -- which isn't possible for most people.
How to invest your retirement account funds
Investing the money in your retirement accounts takes just a few simple steps, including the following:
- Determine your risk tolerance. All investments carry some risk, but typically with higher-risk investments you have the potential to earn better returns(and incur larger losses, too).
- Decide on an appropriate percentage to put into stocks. You should have less equity exposure as you age since you'll rely more on your money as you get older, and you won't be able to afford to wait out market downturns. To determine an ideal percentage of your money to invest in the market, subtract your age from either 120, 110, or 100 (depending on your risk tolerance).
- Choose a diverse mix of different investments. You don't want to bet your entire retirement on just one company or industry. Instead, you can invest in an ETF that gives you broad exposure to the market, such as one tracking the S&P 500 index, or you can buy a mix of different ETFs or shares of individual companies. Obviously, ETF investing is easier and can be less risky, but you could potentially beat the market's performance and earn impressive gains by making informed choices and buying individual stocks.
- Manage your accounts wisely. You'll want to periodically rebalance your portfolio to make sure you're exposed to the right level of risk and haven't become over-invested in any particular industry. You'll also want to make sure you aren't paying excessive fees for your investments, as these fees compound, too.
With these steps, you can grow the money you've worked so hard to contribute and build a nest egg that will help you enjoy a retirement free of financial worries.