The importance of investment diversification in planning for your retirement isn't a new concept. Investing outside your company's 401(k) plan isn't either. Yet, investors can overlook both concepts, with devastating results.
When planning your diversification strategy, it's important to avoid duplication and to be sure your portfolio includes not only different investments, but also different types of investments.
Asset Allocation
Asset allocation means spreading your investment money among a variety of asset classes, which broadly includes stocks, bonds, and cash. Each asset class has different risks and return potential and may respond differently to market conditions such as inflation and interest rate changes. As you move through different stages in your life, the asset allocation model that best fits your situation will likely change. Because of this, you may want to rebalance your portfolio periodically to fit your current financial needs, goals, and risk tolerance.
Determining Your Retirement Need
In addition to asset allocation, there are other components to consider when predicting your retirement needs. Consider these factors: retirement age, retirement lifestyle, inflation, and risk tolerance.
Determine the age at which you hope to retire and the lifestyle you'd like to have during retirement. Many financial planners estimate a person will need about 70 percent to 80 percent of his or her present income to retire at the same standard of living. Investors need to keep in mind some expenses such as mortgage, taxes, and work-related expenses may go down, while others such as health care, travel, or entertainment may go up. There are several retirement planning worksheets and calculators available in books, online, or from a financial planning professional.
Once you've determined how much you think you need for retirement, you can focus on the investments that best fit with your goals and comfort level. Every investment carries some risk. You need to develop a strategy that corresponds to the risk level you're most comfortable with.
Structuring Your Retirement Plan
Again, remember diversification holds a deeper meaning than simply varying your investments within one investment class. Here are a few items to consider:
o Equities, or stocks, are investments that give you an ownership interest in the company issuing the stock. Investors should make sure they buy stock across sectors of the economy for diversification purposes. You can check your investments against the S&P 500, an index that tracks the stocks of 500 leading companies in all major industries.
o Bonds are debt securities, similar to IOUs. When you purchase a bond, you're lending money to an issuer-a government, corporation, or federal agency, for example. In return, the issuer promises to pay you a specified rate of interest for the life of the bond and to repay the principal or face value when the bond matures. The promise to repay principal is part of the obligation, but only if the issuer has the ability, so there are risks even with bonds.
o Mutual funds refer to an investment company that pools the money of many individual investors and uses it to buy a diversified portfolio of securities. Mutual funds could include individual equities, individual bonds, or a combination of both. Be sure to ask about the fees associated with the fund. All mutual funds have associated fees, and some are paid when you purchase the fund or are charged when the fund is sold. Get a list of fees in writing.
There are limits as to how much an individual can contribute to a company's 401(k) plan. An individual retirement account (IRA) is an additional investment vehicle you should consider when saving for retirement. They allow you the opportunity to set up a tax-favored retirement account for yourself and your beneficiaries. Each year, you can make IRA contributions that are invested until you're ready to receive them in retirement. Your contributions won't be tax-deductible; however, earnings grow tax-free, and distributions are generally tax-free in the year received, provided certain requirements are met. TPW