Saving for retirement is challenging enough as it is, but it can be particularly difficult if you're unsure about how, exactly, to invest your money. It's tough to ensure you're doing everything possible to save enough for retirement, and that's especially true you don't have a strong grasp of financial language and concepts.
Asset allocation refers to the specific stocks, bonds, and other assets you're investing in when you contribute money to your retirement account, and it can be a confusing topic. But there's one simple error that half of Americans may be making that's related to asset allocation -- and it could potentially wreck your entire retirement plan.
The problem with putting all your eggs in one basket
According to a recent survey from J.D. Power, approximately 50% of Americans aren't sure whether it's safer to invest all your cash in a single company's stock or invest in a mutual fund. Around 10% of those respondents believe it's safer to invest in a single stock, while the other 40% said they don't know which option is safer.
The problem with investing in a single stock is that you're essentially putting all your eggs in one basket. If that stock performs well, you could potentially stand to see lucrative investment gains. But there's also always a chance that a stock will perform poorly -- and there are many reasons why a company might underperform. If your life savings are invested in a single company's stock and that business goes under, you could lose a lot of money.
However, when you invest in index and mutual funds, you're diversifying your investments and limiting your risk. Index and mutual funds are essentially large collections of stocks and bonds. So by investing in a single fund, you're actually investing in dozens or even hundreds of different stocks at once. That means if one or two of those stocks within the fund takes a nosedive, it won't cause your entire investment portfolio to tank.
Although asset allocation can quickly get to be a complicated topic, understanding a few general allocation principles is crucial if you want to ensure you're investing your money in the right places. If you're not diversifying your investments enough, your retirement fund could lose a lot of value in a short amount of time. But by using smart investment strategies, you can limit your risk while still reaping rewards.
What does the ideal investment portfolio look like?
One of the tough parts of deciding how to invest your money is that the answer won't be the same for everyone. There's no one right way to invest, so what works for one person may not work for another.
A major factor to consider when determining your strategy is your tolerance for risk. Although it's not a good idea to invest all of your cash in a single stock, you may choose to weight your portfolio more heavily toward a collection of individual stocks rather than investing in bonds. Certainly, you may see higher returns when you invest in stocks, but the downside is that stocks are also more susceptible to volatile ups and downs.
Investing heavily in stocks is generally a better idea when you're young and still have decades until retirement. Although you'll have good years and bad years, in general, the stock market does tend to provide positive returns over time. So in the early years of your professional career, the potential rewards often outweigh the potential risks.
As you get older, it's oftentimes a good idea to start allocating more of your money toward bonds. You'll still want to invest in stocks to some degree, but the closer you get to retirement age, the more you'll want to avoid the roller-coaster ups and downs that you may see by investing mostly in stocks. Bonds typically have lower rates of returns than stocks, but they also don't carry as much risk.
How to get started
Once you have an idea of how you want to invest your money, how, exactly, do you get started? It's easier than you may think.
When you invest in a 401(k) or IRA, you may not have to choose which specific index or mutual funds you want to invest in. Rather, your plan may simply ask about your risk preferences and then invest your funds accordingly. From there, all you have to do is start saving. That said, it is a good idea to check in on your asset allocation occasionally to make updates as necessary. As you get closer to retirement age, for instance, you may want to play it a little safer with your investments. Or if you realize you've been too safe with your money and still have plenty of time left to save, you may want to take a more aggressive approach.
Many retirement plans also offer target-date funds, which is a type of fund that automatically adjusts your asset allocation based on the year you plan to retire -- what's considered your "target date." As you get closer to your target date, the fund will adjust your investments to be more conservative. There are advantages and disadvantages to using a target-date fund, but one of the major perks is that you can take a hands-off approach while still knowing your investments are properly diversified.
Asset allocation may not excite you, but it's important to at least understand the basics to make sure you're setting your investments up for success. The better you're able to manage your risk versus reward, the more likely you are to build a solid nest egg that will last through retirement.