Mak­ing deci­sions about your retire­ment account can seem over­whelm­ing, espe­cial­ly if you feel unsure about your knowl­edge of invest­ments.  How­ev­er, the fol­low­ing basic rules can help you make smarter choic­es regard­less of whether you have some invest­ing expe­ri­ence or are just get­ting started. 


Don’t lose ground to inflation

It’s easy to see how infla­tion affects gas prices, elec­tric bills, and the cost of food; over time, your mon­ey buys less and less.  But what infla­tion does to your invest­ments isn’t always as obvi­ous.  Let’s say your mon­ey is earn­ing 4% and infla­tion is run­ning between 3% and 4% (its his­tor­i­cal aver­age).  That means your invest­ments are earn­ing only 1% at best.  And that’s not count­ing any oth­er costs; even in a tax-deferred retire­ment account such as a 401(k), you’ll even­tu­al­ly owe tax­es on that mon­ey.  Unless your retire­ment port­fo­lio at least keeps pace with infla­tion, you could actu­al­ly be los­ing mon­ey with­out even real­iz­ing it. 

What does that mean for your retire­ment strat­e­gy?  First, you’ll prob­a­bly need to con­tribute more to your retire­ment plan than you think.  What seems like a healthy sum now will seem small­er and small­er over time; at a 3% annu­al infla­tion rate, some­thing that costs $100 today would cost $181 in 20 years.  That means you’ll prob­a­bly need a big­ger retire­ment nest egg than you antic­i­pat­ed.  And don’t for­get that peo­ple are liv­ing much longer now than they used to.  You might need your retire­ment sav­ings to last a lot longer than you expect, and infla­tion is like­ly to con­tin­ue increas­ing prices over that time.   Con­sid­er increas­ing your 401(k) con­tri­bu­tion each year by at least enough to over­come the effects of inflation. 

Sec­ond, you need to con­sid­er invest­ing at least a por­tion of your retire­ment plan in invest­ments that can help keep infla­tion from silent­ly eat­ing away at the pur­chas­ing pow­er of your sav­ings.  Cash equiv­a­lents may be rel­a­tive safe, but they are the most like­ly to lose pur­chas­ing pow­er to infla­tion over time.  Even if you con­sid­er your­self a con­ser­v­a­tive investor, remem­ber that stocks his­tor­i­cal­ly have pro­vid­ed high­er long-term total returns that cash equiv­a­lents or bonds, even though they also involve greater risk of volatil­i­ty and poten­tial loss. 


Invest based on your time horizon

Your time hori­zon is invest­ment-speak for the amount of time you have left until you plan to use the mon­ey you’re invest­ing.  Why is your time hori­zon impor­tant?  Because it can affect how well your port­fo­lio can han­dle the ups and downs of the finan­cial mar­kets.  Some­one who was plan­ning to retire in 2008 and was heav­i­ly invest­ed in the stock mar­ket faced dif­fer­ent chal­lenges from the finan­cial cri­sis than some­one who was invest­ing for a retire­ment that was many years away, because the per­son near­ing retire­ment had few­er years left to let their port­fo­lio recov­er from the downturn. 

If you have a long time hori­zon, you may be able to invest a greater per­cent­age of your mon­ey in some­thing that could expe­ri­ence more dra­mat­ic price changes but that might also have greater poten­tial for long-term growth.  Though past per­for­mance doesn’t guar­an­tee future results, the long-term direc­tion of the stock mar­ket has his­tor­i­cal­ly been up despite its fre­quent and some­time mas­sive fluctuations. 

Think long-term for goals that are many years away and invest accord­ing­ly.  The longer you stay with a diver­si­fied port­fo­lio of invest­ments, the more like­ly you are to be able to ride out mar­ket down­turns and improve your oppor­tu­ni­ties for gain. 


Consider your risk tolerance

Anoth­er key fac­tor in your retire­ment invest­ing deci­sions is your risk tolerance—basically, how well you can han­dle a pos­si­ble invest­ment loss.  There are two aspects to risk tol­er­ance.  The first is your finan­cial abil­i­ty to sur­vive a loss.  If you expect to need your mon­ey soon—for exam­ple, if you plan to begin using your retire­ment sav­ings in the next year or so—those needs reduce your abil­i­ty to with­stand even a small loss.  How­ev­er, if you’re invest­ing for the long term, don’t expect to need the mon­ey imme­di­ate­ly, or have oth­er assets to rely on in an emer­gency, your risk tol­er­ance may be higher. 

The sec­ond aspect of risk tol­er­ance is your emo­tion­al abil­i­ty to with­stand the pos­si­bil­i­ty of loss.  If you’re invest­ed in a way that doesn’t let you sleep at night, you may need to con­sid­er reduc­ing the amount of risk in your port­fo­lio.  Many peo­ple think they’re com­fort­able with risk, only to find out when the mar­ket takes a turn for the worse that they’re actu­al­ly a lot less risk-tol­er­ant than they thought.  Often that means they wind up sell­ing in a pan­ic when prices are low­est.  Try to hon­est about how you might react to a mar­ket down­turn, and plan accordingly. 

Remem­ber that there are many way to man­age risk.  For exam­ple, under­stand­ing the poten­tial risks and rewards of each of your invest­ments and its role in your port­fo­lio may help you gauge your emo­tion­al risk tol­er­ance more accu­rate­ly.  Also, hav­ing mon­ey deduct­ed from your pay­check and put into your retire­ment plan helps spread your risk over time.  By invest­ing reg­u­lar­ly, you reduce the chance of invest­ing a large sum just before the mar­ket takes a downturn. 


Integrate retirement with your other financial goals

Make sure you have an emer­gency fund; it can help you avoid need­ing to tap your retire­ment sav­ings before you had planned to.  Gen­er­al­ly, if you with­draw mon­ey from your retire­ment plan before you turn 59 ½, you’ll owe not only the amount of fed­er­al and state income tax on that mon­ey, but also a 10% fed­er­al penal­ty (and pos­si­bly a state penal­ty as well).  There are excep­tions to the penal­ty for pre­ma­ture dis­tri­b­u­tions from a 401(k) (for exam­ple, hav­ing a qual­i­fy­ing dis­abil­i­ty or with­draw­ing mon­ey after leav­ing your employ­er after you turn 55).  How­ev­er, hav­ing a sep­a­rate emer­gency fund can help you avoid an ear­ly dis­tri­b­u­tion and allow your retire­ment mon­ey to stay invested. 

If you have out­stand­ing debt, you’ll need to weigh the ben­e­fits of sav­ing for retire­ment ver­sus pay­ing off that debt as soon as pos­si­ble.  If the inter­est rate you’re pay­ing is high, you might ben­e­fit from pay­ing off at least part of your debt first.  If you’re con­tem­plat­ing bor­row­ing from or mak­ing a with­draw­al from your work­place sav­ings account, make sure you inves­ti­gate using oth­er financ­ing options first, such as loans from banks, cred­it unions, friends, or fam­i­ly.  If your employ­er match­es your con­tri­bu­tions, don’t for­get to fac­tor into your cal­cu­la­tions the loss of that match­ing mon­ey if you choose to focus on pay­ing off debt.  You’ll be giv­ing up what is essen­tial­ly free mon­ey if you don’t at least con­tribute enough to get the employ­er match. To bet­ter define your goals down­load our free goal set­ting workbook. 


Don’t put all your eggs in one basket

Diver­si­fy­ing your retire­ment sav­ings across many dif­fer­ent types of invest­ments can help you man­age the ups and downs of your port­fo­lio.  Dif­fer­ent types of invest­ments may face dif­fer­ent types of risk.  For exam­ple, when most peo­ple think of mar­ket risk—the pos­si­bil­i­ty that an invest­ment will lose val­ue because of a gen­er­al decline in finan­cial mar­kets.  How­ev­er, there are many oth­er types of risk. Bonds face default or cred­it risk (the risk that a bond issuer will not be able to pay the inter­est owed on its bonds, or repay the prin­ci­pal bor­rowed).  Bonds also face inter­est rate risk, because bond prices gen­er­al­ly fall when inter­est rates rise.  Inter­na­tion­al investors may face cur­ren­cy risk if exchange rates between U.S. and for­eign cur­ren­cies affect the val­ue of a for­eign invest­ment.  Polit­i­cal risk is cre­at­ed by leg­isla­tive actions (or the lack of them). 

These are only a few of the var­i­ous types of risk.  How­ev­er, one invest­ment may respond to the same set of cir­cum­stances very dif­fer­ent­ly than anoth­er, and thus involve dif­fer­ent risks.  Putting your mon­ey into many dif­fer­ent secu­ri­ties, as a mutu­al fund does, is one way to spread your risk.  Anoth­er is to invest in sev­er­al dif­fer­ent types of investments—for exam­ple stocks, bonds, and cash alter­na­tives.  Spread­ing your port­fo­lio over sev­er­al dif­fer­ent types of invest­ments can help you man­age the types and lev­el of risk you face. 

Par­tic­i­pat­ing in your retire­ment plan is prob­a­bly more impor­tant than any indi­vid­ual invest­ing deci­sion you’ll make.  Keep it sim­ple, stick with it, and time will be your best ally. 



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Any tax advice includ­ed in this writ­ten or elec­tron­ic com­mu­ni­ca­tion was not intend­ed or writ­ten to be used, and it can­not be used by the tax­pay­er, for the pur­pose of avoid­ing any penal­ties that may be imposed on the tax­pay­er by any gov­ern­ment tax­ing author­i­ty or agency. 
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