In our first few lessons I talked about the types of risks people should be taking depending upon their ages, and how to play it smart when you want to be risky and or when you are close to retirement. This lesson will focus on categorizing your major investment choices in your 401k. Within your 401k plan or similar, you will be able to select to invest in Bonds, Stocks, Cash, and or other small categories like Real Estate and such (considered long term choices).You can invest in all or one, or none for that matter. In addition, you have shorter term choices such as money markets, CD’s from your bank and or other savings type accounts. For now, we will discuss the long term options in greater detail, because we are focused on retirement planning here.
So, what are these different types of assets and how much of each would be the best for you? First, let’s start off with talking about what each category or asset type within your investment choices are:
Bonds: this type of asset is the rather secure or less risky than stocks. In general, bonds offer set interest payments for your investment. Bonds are typically sold by governments and corporations to pay for different things. The US federal government sells all sorts of different bonds to help build bridges, highways, and a bunch of other stuff. Government has a plan to generate the money to pay off the bonds through different means and in case of the US government, they have an excellent track record of paying back what they are supposed to. Because these payments have almost always been paid back, they aren’t considered very risky, and the amount of money they pay you in return for investing in them is substantially lower than other more risky asset options. There’s also municipal bonds, offered by none other than local municipalities. Corporations and other types of entities have these same investments that governments offer, however, they may be slightly riskier as they are only backed by townships and or a Corporations good name.
Stocks: Stocks are the biggest chunk of an average investors portfolio (or mix of assets). You can find so many different types of stocks, it would blow your mind. Stocks offer the greatest potential for growth and at the same time the greatest risk for loss. Stocks can be very risky or not risky at all, it depends on the nature of the stock in question. Stocks can pay dividends or payments to shareholders for holding the stock which can offer some (semi-fixed) income for retirement. Most 401k investors or similar invest in stocks by buying mutual funds or exchange traded funds. Companies like Vanguard or Fidelity buy up a pool of stocks, sometimes similar, sometimes very different, and individual investors can buy into all of those different companies or industries or geographies by simply purchasing shares of the mutual funds.
Cash: This is less risky than Bonds and is even backed in some cases by the Federal Government of the USA, but it is the least profitable. When you put some of your money into cash, you are typically investing in different types of savings accounts, money markets, or various other things. The biggest problem with investing in cash is the risk of inflation (when your money buys less and less due to rising cost of living or an increase in the money supply). You can hedge this risk of inflation by investing in different marketable securities such as TIPS.
Real Estate and other types of Investments: There are many small investments you may elect to invest your cash in, however, keep in mind that each one of these has their own set of risks and rewards. You can invest in real estate through mutual funds, or by acquiring your own properties.
Now that you understand what each of the major categories you can start to think about how to allocate your assets within your 401k based upon your retirement needs and your risk tolerance. So, when we talk about “asset allocation,” we are really talking about how you should spread your investments among the different options available.
In the following lessons, we will discuss how you determine what mix of assets would best suit you, or a typical person of a certain age.
If you’re only interested in 401k plans and don’t care to learn about this, feel free to skip the next lesson and move on to Getting down to the details. This lesson talks about how my 401k plan is setup and general rules that can be used to setup your plan (deciding your asset mix).
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