You set up your retirement account, but what investments should you invest in? This varies greatly with each individual, but here are a few things to consider.
How long until you will be drawing money from the account?
The amount of time before you will be using your money will change your risks. Over the short time frame of a year or two, the volatility or changes of price in stocks will be your biggest risk. However, over longer periods of 10 years or more, your biggest risk becomes inflation. Inflation is almost guaranteed to eat away the purchasing power of investments in “safe” CDs and bonds. While the longer time period smooths out the possible returns of investments of more volatile stocks. The longer the period of time before you will be taking money from the account, the more volatility you are able to take on. For this increased volatility, you will be rewarded with higher returns. Many of the highest returning investments can vary greatly over months or a couple years, but these variations tend to average out to higher returns over a period of several years.
For example, you could buy a bank CD for a year that returns 1.3% that has virtually no risk of going down, or you could buy an S&P 500 ETF for a year that could go up 57%, but could also down 44% in one year. However, if you invested in a CD for 10 years you could get a return of 2.5% with virtually no volatility, but investing in an S&P 500 ETF has returned between -5% and 22% per year for 10 year periods with an average of over 10% annual returns.
This means that if you are going to use the money within a year, a more stable investment will be better for you because stocks are too likely to lose money over such a short time period. However, if your time horizon is over 10 years, stocks become a better investment because less volatile investments will lose too much purchasing power, while the returns on stocks become much less volatile.
Remember that the majority of your money will still be a long-term investment even when you reach retirement. Let’s say a couple retires at age 65. The average age at least one will live is 90 years old. This is still 25 years away. You may also want to leave money behind to family, friends, or charity. These investments will also be long-term investments.
What is your tolerance for risk or change in price?
Market downturns can be scary. Imagine seeing your retirement account, that you spent years building go from $100,000 to $60,000. Would you want to cut your losses to prevent losing more money? This is the exact reason a high percentage of people do worse than the market they are investing in. When prices are “on sale” for almost any item, people know it is time to buy, but for stocks, people often do the exact opposite and sell. It is emotional to see your account drop so drastically, so if you know that you are the type of person that would sell, it is very important for you to reduce the amount of exposure to volatile investments that have big swings in price. This will reduce your overall returns, but not nearly as much as selling when prices are at their lowest. You will need to find the balance between higher returns and the perception of safety to prevent emotional reactions that cause selling at the worst times.
How much time do you want to spend researching investments and making adjustments?
There is more information on stocks the possible for any single human to take in. You could spend all of your waking hours researching stocks and still not know everything. Picking stocks is a zero-sum game, meaning that for someone to make above average returns, someone else has to do worse than the market. When you decide to choose and pick stocks for yourself, you are competing against professional stock pickers that spend at least 8 hours a day researching stocks. Even the majority of professionals still underperform the market due to trading fees and expenses. The other thing that you must consider is the opportunity cost. What other things could you spend your time doing that would be more fulfilling for you? I love researching investments, but many people would rather spend their free time doing other things.
Should I hire an investment advisor?
I believe that you can have excellent results with less effort choosing investments than it would take to choose an investment advisor. The problem with choosing investment advisors is that you must determine both their integrity and their ability. However, the nature of investing business makes it difficult to determine either. If you don’t already know enough to invest for yourself, you won’t know enough to know you are being taken advantage of. Also, there is a high component of luck in determining short-term investment returns that is indistinguishable from skill that can only be statistically determined after decades of data and market conditions will likely be different and those investors will probably no longer be accepting money.
I will give my recommendations for the specific investments and asset allocations best suited for various situations in the next post “Investment Recommendations“.