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Digging Deeper -
05-29-2008
“Experts recommend that you spread your money among a range of investments that your money is diversified.”
You will probably want to dig deeper by assigning different rates of return to different pots of money - workplace savings accounts, IRAs, bank savings accounts - you have put aside for retirement. Let's say you have $2,000 in a checking account that you never use. Your rate of return, in this case, with interest compounded monthly, will be low, maybe 1 percent. But your money is safe. Then let's say you've invested in a stock mutual fund for 15 years using your retirement plan account and you get a return of 11 percent. Investments in securities can bring a higher rate of return than simple interest because prices of securities often rise and gains are compounded. Of course, security prices can fall, as we saw with stocks in 2000 and 2001. The tradeoff for aiming for higher returns is taking on more risk, including the risk of losing money. Keep this in mind in selecting rates of return for the Pre-Retirement Savings/Assets Worksheet.
In the example above, with some money invested in stocks and some in a safer, interest-bearing account, you are already doing what the experts recommend. You are practicing "asset allocation" - by putting your money in different types of products that earn different rates of return. Financial planners highly recommend this technique as a way to spread risk. A general allocation is to have some money in "cash," such as a savings, checking, or money market account with little or no risk; some money in bonds, with a little more risk but paying more interest; and some money in stocks, with more risk but a likely higher return, especially in the long run.
Another way to spread your investments among different categories is to invest in index mutual funds. Index funds are a collection of investments, such as bonds or stocks, that closely match the performance of the major holdings for that category of investment. For instance, a Standard and Poor's (S&P) index fund tracks the 500 broad-based stocks that comprise the S&P 500 Index. A bond index fund would track the performance of major bond holdings in that index. In this way, your investment is following the financial market for that particular category.
Experts recommend that you spread your money among a range of investments so that your money is "diversified." In addition, most experts add that you should not only invest among categories but within each major category as well. For instance, your risk of losing money is less if you buy shares in several mutual funds investing in various types of assets (such as large company stocks, small company stocks and bonds). Even investing in just one mutual fund will help you to diversify compared to investing in individual securities on your own, since mutual funds, by their nature, allow you to invest in a collection of stocks, bonds, etc.
Financial planners believe that diversifying your investments helps reduce risk as markets move up and down. For example, in 1980 when some certificates of deposit (CDs) were paying 12 percent, stocks were barely holding their own; but in 1999 most stock prices were rising fast, and CDs were paying 5 percent.
Too much money in one type of investment is always a bad idea and puts your money at risk. For example, many American workers are holding a lot of their employers' stock in their retirement accounts. This ties both your current paycheck and your retirement savings to one employer's success...or failure. This can be risky.
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