Money Girl gives an easy tip for how to pick the best investments in your retirement account.
Q. "I contribute 5% of my income to a retirement account at work that offers 5% matching. I’m disappointed with the plan’s custodian because when I ask him for advice about choosing investments, he isn’t helpful. I’m 31 years old and am comfortable with a moderate amount of investment risk. How should I choose investments for my retirement so I get the best return?"
A. Although choosing investments can seem confusing, don’t let it overwhelm you. Think about the investment menu for your retirement plan being similar to a restaurant menu, with 3 major sections.
Instead of choosing from appetizers, entrees, and desserts, you get to pick from stocks, bonds, and cash. You simply need to choose the right combination for your situation. Here's a summary of each investment type:
Stocks are inherently the most risky investment option because prices can fluctuate wildly—but they also have the most potential to grow and give you the highest returns. Almost every investor should own stocks, stock mutual funds, or stock exchange-traded funds (ETFs). If you’re young or have a high tolerance for investment risk, the majority of your portfolio should be in stocks.
Bonds are less risky than stocks because their value doesn’t fluctuate so much and you receive a fixed investment return. Owning bond mutual funds or bond ETFs gives you a lower investment return, but more stability. Owning some amount of bonds is a smart way to dial back the risk in your portfolio.
Cash is the least risky option because the value never changes; however, it can lose value due to inflation. Most workplace retirement menus include a money market fund, which is a very safe, but low-return cash-equivalent.
All investors should have a cash emergency fund equal to at least 6 months' worth of living expenes. However, my advice is to keep it in an FDIC-insured bank account so you can access it easily and without a penalty. Tapping most traditional retirement accounts before age 59-1/2 comes with a steep 10% early withdrawal penaly, in addition to ordinary income tax.
Here’s a quick and dirty tip: Subtract your age from 100 or 110 to figure the percentage of stocks that should make up your portfolio. For instance, a 31-year-old investor should own approximately 79% (110 – 31 = 79) to 69% (100 – 31 = 69) stocks. That means a portfolio valued at $100,000 should have a maximum of $79,000 in stocks. The remaining $21,000 would be held in bonds and perhaps a small amount of cash.
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