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Long-term investing through your 401(k) plan means taking risks, but how much is too much?
Stocks are historically more risky then mutual funds, and cash is the safest bet of all, but many decisions investors make likely will depend on their age and willingness to gamble on the market, says Liz Murphy, a certified financial planner in Ashland.
"There are risky stocks, but people can take some good, calculated risks," she says. "It's possible to invest aggressively without investing speculatively."
Murphy says younger people who start saving money early in their careers can afford to buy riskier stocks, and the common rule of thumb is that people within three to five years of retirement should switch to more stable investments.
"But for the older investor, stable investment is not always the case," she says. "It all depends on your assets and at what age you're retiring."
Baby boomers who retire face a "longevity risk" with their investments, meaning they might spend more time in retirement than they did in their careers because of longer life spans and better medical care, Murphy notes. "So being too conservative too early can set them up to fail," she says.
According to The Wall Street Journal, investors are wise to consider not only how much risk they can afford to take but also how much risk they can stand to take.
What an investor can afford is mainly driven by their time horizon — how long before they will need the money.
Say you have a child heading to college in the next couple of years. That lessens your ability to take risks in time to recover if the value of your portfolio declines. But if your child won't be in college for 10 years, you can take more risks and ride out the ups and downs in the market.
How much risk you can stand to take — the so-called temperamental tolerance for risk — is harder to pin down. That's prompted financial advisers, brokerage firms and mutual-fund companies to create "risk quizzes" to help people determine whether they are conservative, moderate or aggressive investors. Most people rank as middle-of-the-road risk-takers.
Experts warn, however, that the quizzes should be used simply as a first step to assessing risk tolerance.
Here are some options for investing, according to The Journal:
Growth stocks and value stocks are important.
Value stocks can enhance investment strategy because they give investors the opportunity to build on solid companies with sound fundamentals. Growth stocks, meanwhile, often are newer, and they have potential for growth. Experts caution that a few of these in your portfolio can increase earnings, but too many might make your portfolio too risky.
- Currency trading is generally risky, and the same is true when it comes to commodities and futures trading. It might be fun to dabble in these realms, but the risk of losing money is higher, experts caution.
- The bulk of your portfolio should not be in cash, but adding cash brings diversity — which can reduce risk — and a foundation of stability.
"Diversification is key," Murphy says. "A lot of people go awry by trying to guess where the market is going. Even the most brilliant people in this field cannot guess that."