The path to a diversified portfolio requires choosing a variety of investments for your retirement accounts. The challenge you face in saving for retirement is choosing investments for each of the accounts in your overall portfolio while always thinking of the accounts as segments of a combined whole.
In some cases, including most employer plans, you choose from a fixed menu of alternatives. With IRAS and taxable accounts, you have a broader choice. Either way, the more you know about the choices you might make, the more confidently you can decide.
One reason you may select actively managed mutual funds, which are common in employer plan menus, is that professional managers choose the funds’ investments. They also determine when to sell holdings to cash in on capital gains or prevent potential losses — decisions based on the research from a team of investment analysts.
Another appeal is that mutual funds pool assets from many investors, so they are typically able to diversify broadly, providing greater protection against certain kinds of risk. If you are using funds, it’s important to look for those that invest differently from each other. You can check each fund’s prospectus for its most recent list of holdings and for a statement of its investment objective. If you own several funds invested in large-company stock, you’re probably much less diversified than you want to be.
Similarly, you’ll want to choose funds that invest in a way that’s consistent with their stated objectives and style. For example, if you own a long-term bond fund whose manager decides to sell bonds and hold cash because he or she believes interest rates are going to rise, that move will affect the way the fund behaves.
Any style drift, or shift away from the investments you expect the fund to make, may provide short-term gains. But your portfolio will not behave as you expect over the long term.
You may prefer to choose individual securities within some asset classes, or use both individual securities and funds. For example, you might create an equity portfolio of large-company stocks combined with small-company and mid-sized company mutual funds or ETFs. Or you may put together a bond portfolio of intermediate-term Treasury notes and long-term municipal bonds combined with short-term corporate bond funds.
One challenge with an equity portfolio is creating a rich enough mix of industry, market capitalization, or size, and style — that is, growth or value — so you hold some securities that are providing strong returns at any given time. To create a broad mix in a fixed-income portfolio, you’ll want to consider term, issuer, and credit quality, since the highest-rated bonds tend to pay the lowest rates.
Once you’ve built a portfolio of individual securities, you’re also responsible for deciding if and when to sell certain ones. Failing to shed investments that are unlikely to provide consistent future returns can be a drag on performance. Despite the added work that may be involved, you may find this approach more rewarding personally and financially than a more hands-off investment style.
You can also invest in specific asset classes through managed accounts. To have access to the services of a professional investment manager, you work with your financial adviser or broker to select account managers who specialize in the asset classes you want to include in your portfolio.
For example, you might select a manager for US equities, another for non-US equities, and a third for long-term debt. There are also multi-manager accounts, which allow you to spread a certain amount of money across several asset classes. Or, you might prefer a portfolio that combines managed accounts with individual securities and various funds.
Index funds and ETFs
One reason index funds and index-based ETFs may attract your attention is that they’re designed to replicate — not beat — the results of the indexes they track. That means there is no issue of these funds making other investments — including those in a different asset class — to improve their return. As a result, they have little style drift.
In addition, index and index-based funds are transparent. That means you know at all times what the fund owns: the securities in the index. Further, turnover tends to be limited to transactions that reflect changes in the index itself. That keeps buying and selling within the funds to a minimum, reducing your short-term capital gains and making the funds more tax-efficient than many managed funds.
Of course, index funds and ETFs have their shortcomings — including their performance in a falling market and the extent to which weighting impacts their returns. But very few managed funds outperform index funds year in and year out, and they cost more to own.
In the past, influential economists have suggested that between 10 and 30 individual securities were adequate for an individual investor who wanted to manage investment risk. For example, Burton Malkiel, in A Random Walk Down Wall Street, concluded that if you owned a well-diversified portfolio of 20 equally weighted stocks, you had as much risk reduction as you were going to achieve.
More recently, others have suggested a higher number is more appropriate, based in part on the difficulty of choosing specific securities and in part because the increased volatility of the markets as a whole makes it more difficult to anticipate returns.
The 4 Types Of Investments To Consider For Retirement Account by Inna Rosputnia
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