Your Investment Time Horizon is the length of time that your money will be invested. An investor many years away from retirement will need to be more aggressive than an investor very near to retirement, because of the increased risk that inflation will erode the value of a long-term investment.
Another factor to consider when choosing investments for a portfolio is volatility. Volatility is a measurement of how much the value of an investment changes, either increasing or decreasing in value. When comparing aggressive investments like stocks, to conservative investments such as bonds, you will notice that stocks can be significantly more volatile.
Because of this increased volatility, you can understand why an investor close to retirement would not want to have the majority of their retirement savings invested in stocks. The investor near retirement age should maintain a more conservative mix of investments that provide stable, more predictable returns. On the other hand, an investor many years from retirement should take the opportunity to be aggressive while they're young, to increase overall investment returns. Extreme volatility in investment returns is more appropriate for the investor with a long time horizon. This is because the investments will not have to be sold any time in the near future. So, if the value of an investment significantly decreases in a short period of time, there are many years left for the investment to recover.
All too often investors assume that their time horizon is the number of years between today and retirement age. This assumption is not entirely correct. Your time horizon is the number of years the money will remain invested - this must include the years during retirement. When you begin your retirement, your time horizon has not suddenly ended, in fact, you'll probably need to make your investments last another 15 or 30 years. This, in conjunction with the risk that inflation will continue to erode the value of your investments, is why you'll need to maintain some growth investments in your portfolio - even during retirement.
Your personal comfort level with assuming risk in an investment is purely an individual decision. However, many investors are far too conservative with their investments because their knowledge regarding risk is limited to judging an investment by its short-term volatility. For example, many people will say that stocks are always riskier than bonds. While this may be true for a short-term investment, its not the case for long-term investing. Again, when you factor in the effects of inflation, conservative investments like bonds become very risky when investing for the long-haul.
To determine your risk tolerance consider the following:
- Your time horizon should be the first and most important consideration. A longer time horizon requires more aggressive investing. You will never get further away from retirement than you are today - so be aggressive while time is on your side.
- If the value of a long-term investment in your portfolio declines by 15% in a few months, would you be tempted to sell, or would you keep the investment, reminding yourself that a few months is not long-term?
- Is there a possibility that you might terminate your employment in the near future and spend your retirement savings on a short-term goal, like moving expenses or a down payment for a new home? If this is the case, you should employ a short-term investment approach.
Asset Allocation is the process of reducing your risk by diversifying your retirement savings into several different types of investments - in other words - don't "put all of your eggs in one basket." Just as a mutual fund manager wouldn't put all of the fund's money in one stock, you shouldn't invest all of your money in one fund or even one asset class.
To determine how your assets should be allocated you'll want to consider all of the topics discussed on the preceding pages - Time Horizon, Life Expectancy, and Risk Tolerance. You'll also want to factor in more subjective information about yourself, such as your general health, the length of time your ancestors lived, and kind of lifestyle you intend to have during retirement.
Most long-term investors consider three different "types" of investments called "asset classes," see below:
- Stocks (also referred to as equities)
- Bonds (fixed-income investments)
- Cash Equivalents & Stable Value Investments
These are essentially short-term loans. They represent some of the most conservative investment options available, and are most suitable for the investor that considers preservation of principal (not losing any value of your initial investment) the most important investment objective. Cash equivalents derive their investment return solely from interest income. Some of the most common forms of cash equivalent investments are Money Markets or mutual funds that invest in money markets. The most common form of money market securities is commercial paper, which are very short-term loans, generally, less than 30 days, and often only overnight. These loans are made to reputable, established corporations or governments with very high credit ratings. The rates of return, which are derived from the interest paid on these short-term loans, is generally very low. That's because there's very little risk involved, remember, these loans were made for a very short period of time to organizations with outstanding credit.
Bank's savings accounts and certificates of deposit (CDs) are referred to as Stable Value Investments, because of a contractual guarantee by the issuing organization to return your principal (original investment). In a savings account, the money you invest earns interest. Interest rates are adjusted by the bank according to the current economic climate. When you invest money in a CD, you are agreeing to leave your money invested for specified period of time; for example, 3 or 5 years. In return, the financial institution guarantees the interest rate will not change until maturity. Bank investments are insured by the FDIC up to $100,000.
Another form of Stable Value investments are Guaranteed Interest Contracts (GICs). These are most often found in pension plans. GICs work very similarly to CDs, except they are purchased through and guaranteed by insurance companies instead of banks and the FDIC. A pension plan usually purchases GICs in increments of $5 million or more which generally increases the rate of interest over bank investments.
Cash equivalents and Stable Value Investments are excellent for the short-term investor, because they offer some guarantee of returning the principal with a modest rate of return. They don't, however, make very good long-term investments. At times lower rates of return associated with cash equivalents barely keep up with, and can sometimes trail the rate of inflation.
Bonds are also investments that represent a loan. The entity issuing the bond (borrower) promises to repay all of your money plus the stated interest within a specified period of time, similar to cash equivalents. Bonds are suitable for the investor that is willing to take a little more risk than cash equivalent investments in exchange for the potential to earn a higher return. Bonds have generally outperformed cash equivalents without the extreme ups and downs (volatility) of stocks.
The rate of return from bond investments is higher than cash equivalents because:
(1) The issuer (corporation or government) is borrowing the money for a longer period of time (usually 2-30 years). A bond issued with a greater time period to maturity (length of loan or "term") demands a higher interest rate. That's because there is an increased possibility that changing economic conditions might effect the value of the bonds or the issuer's ability to repay. Additionally, when money is loaned for many years, one would expect a higher return than money loaned for a few months.
(2) The issuer's credit worthiness, or ability to repay, may or may not be questionable. The entity borrowing your money could be the federal government or one of its' agencies, a municipality or a corporation. When one of these entities wants to raise money, they may issue bonds to the general public. An independent rating service, such as Standard & Poors, will assign a rating to the bond which represents their opinion of the issuer's ability to repay. Bonds with very high ratings (AAA, AA, A) will have lower rates of return, because the issuer's credit worthiness is deemed to be very strong. On the other hand, bonds with lower ratings (BBB, BB, B, B-) will offer higher rates of return because their ability to repay is questionable and therefore the risk is greater. Bonds assigned the lowest ratings (CCC, CC, C, D) are the riskiest, because the issuer is already having difficulty or unable to repay.
Other fixed income investments such as real estate loans function similarly. Loans with longer terms or greater risk, demand higher yields. Bonds derive their investment return primarily from interest income. However, in addition to the interest income, bonds may also experience some appreciation or depreciation in value. This is called Interest Rate Risk, see below. This can make a bond's returns fluctuate or change over time. This volatility in returns is additional risk that bonds have in comparison to cash equivalents and stable value investments. Historically, this volatility, or fluctuation in return, is not as high as investing in stocks.
Stock is issued by corporations as a means of raising capital (money) to invest in the corporation in an effort to make the company grow. When you buy stock in a company you are trading your money for a piece (share) of ownership in the company. As a stockholder (partial owner), you share in the company's profits and losses. When the value of the company increases and decreases, the value of your investment increases and decreases. The value of a stock can change substantially even in one day. Additionally, there are no guarantees or promises associated with stocks, unlike bonds and cash equivalents, which represent loans with a promise to repay. Therefore, stock investments are most suitable for the investor with a long time-horizon, because the long-term investor doesn't have to worry about short-term fluctuations in value. The appreciation in value of stocks is the primary source of investment return, because stocks do not pay very much income in the form of dividends.
Other growth investments include real estate, precious metals like gold and silver, stock mutual funds, and exotic investments such as antiques, coins and other collectables. When you invest money in any of these growth investments, you pay a specific price at the time of purchase and hope to sell the investment at some point in the future for a profit (more than you paid). The increase in value or profit is your investment return.
The most common growth investments in pension plans, including the CCOERA plans, are mutual funds that buy stock, so we'll focus primarily on this type of growth investment. There are many types of stocks for an investor to purchase, and your risk level is determined by the type of stock you purchase. For example, an investment in a foreign company or small domestic company is generally much riskier than an investment in a very large, established corporation.
Historically, stocks have outperformed the other major asset classes over the long-term, making them an excellent investment for a long-term savings goal, such as retirement.
These are the most common investments found in any self-directed retirement plan, including your CCOERA retirement savings plans. Mutual funds are investment companies that allow investors to pool their money together and have a team of professional money managers select and manage a large number of investments with all of the money in the fund. When you invest money in a mutual fund, you are exchanging your money for pieces (shares) of ownership in the fund, similar to purchasing shares of stock. However, when you purchase shares of a mutual fund, you are purchasing a very small portion of every investment the fund owns. The value of your shares will increase and decrease as the value of all the investments in the fund increase and decrease. By pooling your money with other investors you create several advantages for yourself over individual investing:
- Expertise & Resources of Professional Money Managers
- Immediate Diversification
- Ability to Purchase High-Priced Stocks - With Small Amounts of Money
- Reduced Investment Expense
Perhaps the most significant advantage to mutual fund investing is the access to Professional Money Managers. Prior to mutual funds, only extremely wealthy individuals could afford to hire professionals to manage their money. However, by pooling your money with other investors, together you create a portfolio large enough to hire an entire team of managers and analysts to make all of the investments decisions. This team of professionals, using information resources out-of-reach for the individual investor, will research investments and decide which ones to buy, sell, or hold - and when to make those transactions. In short, mutual funds allow the investor with little or no knowledge of markets and investing, low-cost access to professional money management.
Another major benefit of mutual fund investing is Immediate Diversification. Because the managers of the fund have such large amounts of money to invest, they can spread it out over hundreds of companies in many different industries. This risk reduction strategy certainly makes more sense than putting all of your retirement savings into one stock, and hoping you'll get lucky. Nobody can consistently predict which stocks are going to be the winners and which will be losers. So the best approach is to diversify - don't "put all your eggs in one basket." By diversifying your investment into several different stocks, you're preventing yourself from investing all of your money in the big loser nobody predicted, and you increase your chances of owning a piece of the big winner.
Additionally, mutual fund investors have access to high-priced stocks, because you're purchasing them in a fund with many other investors. Finally, the cost of money management and investment expense is shared by all of the investors in the fund, making it relatively small in comparison to hiring a private manager or broker.
Market Risk is the chance that a growth investment, such as stock or real estate, may decrease in value due to a change in the economy not necessarily related to the specific investment. Nearly everybody knows someone that has purchased a growth investment, only to to see the value go down rapidly, due to changing market conditions. The frantic investor will be inclined to sell an investment that's losing money, because it's human nature to get out before it loses any more. However, for long-term investors, this is generally the last thing you want to do. When you purchase a growth investment there should always be a long-term commitment.
With market risk, you need to realize that short-term market ups and downs are to be expected, and when the market heads south, remind yourself that this was a long-term investment. Generally, the only growth investors that lose money to market risk are investors with short-term temperament. Additionally, to reduce your exposure to market risk you should diversify your investments, so that you're not subject just to one type of market.
This type of risk is generally associated with bonds. Remember, bonds represent a loan with a promise to repay principal plus interest. Credit risk is the risk that the borrower may not be able to repay the interest, or principal, or both.
To minimize your exposure to credit risk, you can invest in a diversified portfolio of many bonds in a bond mutual fund. Also, consider funds that, on average, have high credit quality ratings from the independent rating services.
This type of risk is also associated with bonds. Interest Rate Risk is the risk that interest rates may go up after you purchase a bond, which would make your bond decrease in value. For example, if you purchase a $10,000 30-year government bond with an interest rate of 7%, and the interest rates increase on 30-year bonds to 8%, your 7% bond just decreased in value. You won't find an investor willing to buy your 30-year 7% bond for $10,000 when they can go buy the same bond at 8%. Therefore, you will have to sell your bond for less than you paid (discount), representing depreciation in value.
You can decrease interest rate risk by investing in short and intermediate-term bonds these tend to retain their value better in a rising interest rate environment.