Understanding risk tolerance and asset allocation
The first step is to decide the level of risk you're comfortable with. Higher-risk investments can generate high rewards, but they also can result in large losses. Generally, investing in stocks produces the highest returns, while investing in bonds increases the stability of your portfolio's value.
Younger people saving for retirement can invest primarily in stocks to maximize the growth of their portfolio's value, since they have more time to recover if it incurs large losses. Later in life, those same investors can concentrate their portfolios more heavily in bonds as they approach retirement and their risk tolerance decreases.
Some investors choose to further diversify their portfolios through asset allocation. Basically, this means holding more than one asset class in your investment portfolio. This could include equities such as stocks and funds, fixed-income investments such as bonds, and cash or CDs.
This kind of portfolio diversification is key to managing the risks of individual investments. Mutual funds and exchange-traded funds (ETFs), which provide automatic exposure to hundreds or even thousands of companies, are great options to help any beginner investor diversify their holdings.
Having a mix of investment account types is also a good idea. Investing in a tax-advantaged retirement account, such as a 401(k) or an individual retirement account (IRA), is a smart choice for any eligible investor. You may also want to establish a taxable brokerage account, which enables you to access your money at any time without paying an early withdrawal penalty.
Diversifying your portfolio is also a smart strategy. Traditional 401(k)s and IRAs can accept pretax dollars as contributions, with taxation occurring on withdrawals in retirement. Roth 401(k)s and Roth IRAs accept after-tax dollars, which enables tax-free withdrawals in retirement. Maintaining a combination of traditional and Roth accounts can help you save on taxes both now and in retirement.
