Monday, March 18

6. Managing Your Retirement Accounts to Meet Your Goals

Managing_AccountsThe first goal of investing money in retirement savings plans is usually to grow your money – to produce a profit or positive return on the money you've saved. The second goal, and just as important, is to protect that pot of money so that it provides dependable income for you during retirement.

Even though retirement accounts typically offer relatively conservative options, even in their "growth" options, there is always the possibility that investments will produce a loss or won't produce the expected return or rate of return. Anyone who had a retirement fund during the economic meltdown of 2008-2009 understands that. To varying degrees, the future value of all investments is always uncertain or unpredictable. The possibility that an investment might under-perform or lose value is called "risk."

The reality of risk is one important reason that you should regularly review the investment options in your retirement account. Your goals should be to make sure that the investments are diversified and balance your goals for growth or income and the level of risk you can tolerate related to those goals.

Different degrees and sources of risk. Different types of investment options have different degrees of risk, generally quantified as low-risk, medium-risk, and high-risk. Risk also comes from several different sources, not all of which affect every type investment equally. For example, inflation risk will decrease the value in purchasing power of every type of investment from a "low-risk" passbook savings account to a "higher risk" growth stock fund.

However, the market risk associated with a sharp loss of value on the stock market does not decrease the value of the principal placed in the savings account. But it very well may decrease the value of the principal invested in growth stock mutual fund. The more common types of investment risk include inflation risk, market risk, interest-rate risk, credit risk (the potential for nonpayment on investments offering fixed income such as corporate bonds), business risk (the potential for business invested in to decline or fail), and liquidity risk. Read more on types of investment risk.

The reward/risk tradeoff. The risk of loss and the potential reward of return have a direct relationship for investments. In general, the higher the risk to the money you've invested, the greater the potential return. Conversely, investments that have lower risks typically offer smaller returns. This differential exists because investors are not likely to put their money in riskier ventures unless they know there's the possibility of a greater reward.

Considering risk in your retirement funds. How much risk you are willing to tolerate for growth in your retirement accounts will typically depend on how long you have to invest before retirement.

In your 20s and 30s, it usually makes sense to choose a balance of options that emphasize growth rather than income. For example, an index stock mutual fund contains a selection of individual stocks that reflect one of the stock market indexes. The goal is to match the growth of the capital value of the underlying stocks in addition to any dividends the stocks may pay. At the same time, the stock fund is more volatile—more likely to go up or down in value. On the other hand, a money market mutual fund is composed of investments that pay interest; the capital value of the underlying investment instrument does not grow. It has lower risk of declining in value but also less opportunity for growth.

As you near retirement and have less time to recover from any market losses, most experts recommend that you consider a balanced selection of options that are lower risk and income producing.

Next: 7. Understanding Types of Investments in Retirement Plans