Investing for retirement can seem tricky, but it doesn't have to be. With a little bit of homework, you can construct a bulletproof retirement plan full of safe, income-generating stocks and bonds that can grow your nest egg over time. Specifically, here are the steps you'll need to take:
- Determine a proper asset allocation
- Assess your risk tolerance
- Decide if you should invest in mutual funds, ETFs, or individual stocks
- Open a retirement account
- Choose your investments and build your portfolio
- Do periodic maintenance on your portfolio
Let's take a closer look at each of these:
Determine a proper asset allocation
Asset allocation simply means how much of your investment capital should be invested in each type of assets. Since we're talking about investing for retirement in an IRA, 401(k), or other type of brokerage account, your investment choices can be broken down into three main categories -- stocks, bonds, and cash.
While it's a good idea to hold cash and equivalents in an emergency fund, they're generally not a good idea for a retirement account. In other words, your retirement assets should generally be invested in stocks and bonds, or funds that invest in those two asset classes. You should familiarize yourself with the basic rules of asset allocation, but the main idea is that the younger you are, the more stock-oriented your retirement portfolio should be, and the older you are, the more of your assets should be shifted into bonds.
Assess your risk tolerance
Within the general classifications of stocks and bonds, there is a wide variety of risk. As an example, investing in a long-maturity corporate bond mutual fund is significantly riskier than investing in a short-term Treasury mutual fund.
While retirement assets shouldn't be invested in overly risky investments, there is still some room to decide whether you have more or less risk tolerance than the average investor. For example, if you have significant assets outside of your retirement savings, you might feel a little more comfortable with risk. On the other hand, if you plan to retire at 55 and you're 52, you may have a little less risk tolerance than the average person your age.
Taking a risk-tolerance quiz could help you fine-tune your ideal asset allocation, and give you a better idea of your appetite for risk.
Decide if you should invest in mutual funds, ETFs, or individual stocks
As far as bond investments go, the vast majority of retirement investors should simply buy a few bond index funds.
With stock investments, there's a good case to be made for buying stock-based funds, and there's also a good case to be made for buying individual stocks.
Warren Buffett has said that investing in low-cost index funds is the smartest way to invest in stocks for most people. By doing so, and leaving your investments alone, you're guaranteed to match the market's performance over time, which historically has been quite good.
Now, Buffett didn't mean that people shouldn't ever buy individual stocks in an effort to beat the market. In fact, if you have the time, desire, and knowledge required to research individual stocks, and the discipline not to make rash, emotional investment decisions, we encourage you to do so. However, the point is that if you don't have all of those characteristics, you may want to consider putting your retirement investing on auto-pilot with mutual funds and ETFs.
Open a retirement account
Once you've assessed your risk tolerance and determined your ideal asset allocation, the next step is to open and fund a retirement account, which for most Americans means an IRA.
IRAs come in two basic varieties -- traditional and Roth -- and the main difference between the two is the tax treatment. Traditional IRA contributions may be tax-deductible, but your eventual withdrawals in retirement will count as taxable income. Roth contributions, on the other hand, are not tax-deductible, but qualified withdrawals in retirement are 100% tax-free. Compare the pros and cons of each account type and choose the best for you.
IRAs are offered by most major brokerages, and the investment fees and client features can vary, so check out a few options before deciding.
Choose your investments and build your portfolio
After you've opened and funded your IRA or other retirement account, it's time to select your investments and build your initial retirement portfolio. To help get you started:
- As I mentioned, almost every retirement investor should use funds for their fixed-income investments. There are plenty of good low-cost bond ETFs out there to fit your particular goals and risk tolerance.
- As far as stocks go, a basic S&P 500 index fund or other large-cap fund can be a great backbone for a retirement portfolio. If you want to add some small-cap stocks or international stocks to your portfolio to add diversification and boost your return potential, funds that specialize in those could be a good idea for some of your stock allocation.
- If you've chosen to buy individual stocks, do some research and choose some beginner-friendly stocks, such as these picks from our contributors.
Do periodic maintenance on your portfolio
The final step is an ongoing one -- doing maintenance. For one thing, this means investing future contributions to your retirement account appropriately, and maintaining your desired asset allocation when you do.
It also means doing occasional rebalancing to ensure that your portfolio doesn't become too dependent on any of your investments. As a simplified example, if your target asset allocation is 70% stocks and 30% bonds, a particularly strong year for the stock market could drive your stocks higher, and they could make up 75% of your portfolio. Rebalancing means selling some stocks and buying some bond investments to bring the mix back down to 70%/30%.
Once you've learned the basics of retirement investing, the ongoing maintenance shouldn't take up much of your time, but it's important to do every so often.