The Retirement Corporation of America

The Basics Of Investing For Retirement

Investment Basic #1: The World Divides Neatly Into Three Asset Classes

AN ASSET IS something of value—from money in your pocket, to a certificate of deposit (CD) in the bank. The three main asset classes are:

•  Stocks. When you buy a stock, you become a partial owner of the business. You share in company profits for as long as you own the stock. Ideally, those profits rise over time and you eventually can sell your stock at a profit. There's no guarantee, however. Profits could slump and you might have to sell at a loss. Often, but not always, your share of company profits is paid to you through quarterly dividends.

•  Bonds. When you buy a bond, you are a lender to the business. And while you have no claim on company profits, the company does pay you interest on your investment over the life of the bond. After a period of years, the company repays all of your original investment. Bonds are issued by corporations, cities, states, and the federal government.

•  Cash. Cash is money invested for one year or less. These investments include bank deposits, short-term securities of the United States government, money market mutual funds, and more. The common theme of all cash investments is that they are for very short periods—after which you get your money back.

Investment Basic #2: You Can Invest Directly, or Through Mutual Funds

You can invest directly in stocks, bonds, or cash. Any stockbroker, including brokers that only do business on the Internet, can buy or sell stocks and bonds for you. You can invest in cash through a stockbroker (short-term Treasury issues), a bank (CDs and other interest-paying bank accounts), and a mutual fund company (a money market mutual fund).

You could invest cash simply by walking into your neighborhood bank and buying a CD. To open a brokerage account and buy and sell nearly any stocks or bonds, you're just a phone call away—or just a few clicks away on your computer's keyboard.

However, you would need to sharpen your skills as an investor to go directly into the markets without someone to hold your hand. With many thousands of stocks and bonds to choose from, how could you be sure you were buying the best investment for you?

But you can make things easier by investing through a mutual fund. Mutual funds pool your money with that of thousands of other investors to buy almost anything: stocks, bonds, cash, real estate, and more—in the U.S. and around the world. The typical mutual fund holds $1 billion or more (sometimes much more) in assets, invested by people just like you. All you have to do is choose the fund. Once you have, the fund manager, a skilled investment professional, decides where to invest your money.

Investment Basic #3: Nothing Ventured, Nothing Gained

That's a phrase you'll hear a lot in the Successful Investing & Money Management course. It means the more risk you are willing to take with your money, the higher the return you should be able to earn over time. Here's how that works:

•  Stocks. The most risky, but with the highest historical returns. You're betting on how much a company will earn during the years you own stock. Maybe it will prosper and the price of your stock will rise. But maybe it won't—and the price will plunge. If times turn tough, the company could quit paying a dividend—reducing your return on the investment. If times turn really tough, the company could go bankrupt—reducing the value of your stock to zero. You could earn a fortune on your stock if the company thrives. However, you could lose most—even all—of your original investment if it doesn't.

•  Bonds. There's less risk involved in investing in bonds, which also means a lower return than stocks. A bond is issued for a long period of time, often 30 years. A lot can happen in 30 years. Still, most bonds are paid off, so while a bond isn't as safe as cash, it's pretty safe. As long as the issuer stays afloat, you keep earning the interest which is generally paid out once every six months. Hold on until the bond comes to the end of its life—matures—and you get your original investment back.

•  Cash. There's little risk involved in investing in cash. Therefore your rate of return is less. Your money is invested for a fixed period of time—generally less than one year, after which you get your original investment back, plus whatever interest you have earned. Since cash is often invested in FDIC-insured bank accounts, or in securities of Uncle Sam, you almost always can count on getting your money back.

That's the risk side of things: Greater risk with stocks, moderate risk with bonds, and virtually no risk with cash.

And what about the reward side of things? The yardstick is "total return". That measures whatever income you have earned on the investment from interest payments or dividends. It also measures gains, if any, in the price of the investment. Based on records going back to 1926, here is what each asset class has averaged per year:

•  Stocks 10%

•  Bonds 6%

•  Cash 3%

The more risk you take, the higher the return. You won't earn the same on your investments every year. But, based on more than 75 years of investment history, that's how much you can expect to average per year.

Investment Basic #4: All Investment Risk Is Relative

Think of investment risk and what usually comes to mind is the risk of capital loss. Something unforeseen happens and the value of your investment plunges.

That could happen, since all markets fluctuate over time, up one year and down the next. You could suffer a loss of capital, especially in the stock market, which generally fluctuates the most. But the risk of capital loss isn't the only thing that should concern you. You also must invest your money so it isn't consumed by inflation over the years. There is always some inflation, eating away at the buying power of your money. And although you do risk losing your capital by investing in stocks, they offer the highest potential of inflation-beating growth over time.

There's also the risk of losing part of your investment return to taxes. We will be talking about how to invest your retirement savings for maximum tax advantage in this lesson.

Finally, there is the risk of lost opportunity. You stay invested in cash, settling for a modest return to reduce your investment risk. At the end of 20 years, your nest egg stands at $250,000. Your best friend, Joe, invested his nest egg in stocks. At the end of 20 years, his stands at $750,000. You each had an opportunity to build a rich retirement savings fund. Joe took advantage of that opportunity, but you let it pass you by.

Investment Basic #5: You Can Minimize the Risk of Capital Loss

You are taking a risk any time you invest your money. Even cash could be lost if a bank fails. However, there are powerful weapons you can use to minimize your investment risk.

•  Asset allocation: Dividing your investments among stocks, bonds, and cash. If you've ever heard the expression "don't keep all your eggs in one basket," then you know what asset allocation is all about. Stocks may do poorly one year, and bonds another year. But it's unusual for both stocks and bonds to do badly in the same year. Furthermore, because the risks of investing in cash are so low, a cash investment almost never has a bad year.

•  Diversification: Don't bet everything on a single stock or mutual fund. Spread your money over several different investments—10 stocks instead of one, five bonds instead of one. The odds of one investment turning bad are fairly high. The odds of many investments turning bad at the same time are pretty low.

•  Keeping time on your side: Studies show there's almost a 50-50 chance that diversified stock portfolio will lose money in any given year. Hold that portfolio for five years, and the risk becomes much less. Hold it for 20 years, and the risk of loss is barely 5 percent. Over time,economic growth tends to push all investment returns higher. The longer your investment horizon, the more likely it is that you will easily ride out the occasional bad year and that your nest egg will grow appreciatively over time. Your time horizon shortens as you get close to retirement, so you keep moving into progressively less risky investments.