I have written a lot about the importance of contributing to a 401(k) or IRA on this site, but rarely about how you should invest that money. Truth is, getting money out of your paycheck and into investments is only half the fight. Now it’s time for the second round: As a twenty something investor, how should you allocate your funds?
A note for investing newbies: By asset allocation I am referring to how the money you contribute to your retirement plan, or individual brokerage account, is divided up.
For example, you may only make one monthly IRA contribution, but these funds can then be divided between various mutual funds, stocks, bonds, cash, and other investment vehicles.
Asset Allocation Strategy 101
At its most basic level, a solid investing strategy is to make riskier investments when you have a longer period of time to invest, scaling back your risk as your time to invest passes.
In terms of retirement, this means you should make riskier investments when you are young, and more conservative investments as you age. If done properly, you will have enough invested towards the end of your career so that a very-low risk investment yielding 5 – 7% a year will be all you need to maintain your retirement goals.
Therefore, if you are able to invest in your retirement before turning thirty, it is wise to make relatively risky investments. By risky I do not mean using 100% of your retirement contributions to speculate on penny stocks. By risky I mean investing mostly in growth stocks and funds as opposed to income stocks and funds, or bonds.
Measuring Investment Risk
There is no sure way to know the true risk of any particular investment (if there were the market wouldn’t work). There is, however, information available online about every particular stock, fund, and bond out there. You can quickly get a sense of an investment’s capitalization and prior returns.
For researching mutual funds, my favorite site is Morningstar, which rates funds on a scale of up to five stars, and provides an at-a-glance “style chart”, showing the fund’s relative size and income to growth mix.
In general, small-cap stocks and smaller funds are riskier than large ones, and stocks and funds classified as “growth” are riskier than ones classified as “income”. A growth stock is a company usually focused on reinvesting profits to rapidly expand and increase revenue, whereas an income stock is typically a larger, often diversified company that distributes profits to shareholders via dividends.
While growth stocks are riskier, they are also the stocks than can turn $10,000 into millions. (Think about WalMart, Starbucks, Microsoft, and eBay, for example).
Foreign investments also tend to be riskier than domestic investments, in part because of foreign markets’ increased susceptibility to political changes. Foreign investments can also yield impressive returns, however.
Finally, certain investments are almost unilaterally more conservative (though conservative does not mean no risk). More conservative investments include bonds and ETFs (exchange traded funds).
Finally, there are insured, no-risk investments like certificates of deposits and money. While no-risk investments provide a great way keep liquid savings (like an emergency fund), or save for short-term goals, they should never be a part of a young long-term investor’s allocation strategy.
An Under Thirty Asset Allocation Strategy
I strongly believe young investors should be as aggressive as possible with their investments before turning thirty, and possibly into their mid to late thirties. An aggressive strategy might include investing between 50-75% of funds in foreign stocks or mutual funds, 20-40% in domestic growth stocks or funds, and 5-10% in bonds.
One fund I invest in and recommended two years ago is the Fidelity International Discovery Fund, which has continued to do very well. Given today’s economic climate, I think foreign investments make more sense than ever before. A weaker dollar and domestic troubles like the mortgage crises only serve to bolster the value of foreign holdings.
The most important part of any investing strategy – especially when you are just starting out – is to shrug off short term fluctuations, even losses. No matter what strategy we are following, most of our investments have taken a beating in the last six months.
That does not mean it’s time to pull out of aggressive investments and open a savings account. We will not be able to retire on 2%, 3%, or even 5% annual returns. We need to get an average of an 8%, 9%, or 10% annual return, and the way to do that is to invest aggressively early on and scale back to more conservative plays as we get closer to retirement.
How do you allocate your retirement investments? Are you super-aggressive with your investments? Or do you disagree with an aggressive strategy?