Investment Basics

While you can never completely eliminate the risk of losing money when you invest, you can minimize this risk by carefully choosing investment options tailored to your individual tolerance for risk and return.

Generally, the riskiness of an investment is directly related to its market value volatility. If an investment’s market value increases and decreases frequently and substantially over time, risk increases based on the frequency and severity of value changes. But these more volatile investments are typically the same investments that are capable of generating the highest long term returns. So investors who are younger or have more years until retirement generally will want to put some of their retirement savings in these more risky investments. For these investors, the greater number of years until retirement, also known as “investing time horizon,” provides the time to smooth out the volatile returns while increasing the chances of higher overall long term returns.

Conversely, when you opt for less risky, less volatile investments, you are typically accepting a lower level of potential return in exchange for the peace of mind and more stable returns expected from a narrower range of possible ups and downs. Investors who are older or have fewer years until retirement will generally want to have more of their retirement savings invested in more stable investments since there is less time to recover in the event of a significant drop in market value.

Financial planning experts universally agree that the primary keys to investing success are diversification and proper asset allocation. But what does this really mean?

By choosing a mix of investment types, you spread your risk around. This is called diversification. Diversification is achieved through proper asset allocation. If you put all your eggs in one basket, or in a single investment type, and that “basket” declines in value, your entire retirement savings will suffer. On the other hand, if you divide—or diversify—your retirement savings into different baskets a drop in one investment type can be offset by others that may remain stable or increase.

“92% of a portfolio’s performance depends on the mix of investments, not the specific investments themselves.”
Harry Markowitz, 1990 Nobel Prize in Economics

Perhaps the most important investing principle to remember is to set realistic and logical expectations for your investment returns. Although some investment options available in your retirement savings plan will produce unusually large rates of return in certain years, rarely—if ever—are these returns sustained for prolonged periods.

If you expect higher returns than are realistic, you will end up under-saving for your retirement.

Part of setting the right expectations is to discover and recognize the type of investor you are—can you handle risk? Do you prefer to keep it simple? Do you have a long time to invest or only a few years? Knowing this will make saving for retirement rewarding and less stressful.