“Tell me and I forget, teach me and I remember, involve me and I learn.” Benjamin Franklin
Last month’s column focused on how to invest retirement savings buckets. Whether monies are placed in an IRA, Roth IRA or an employer-sponsored plan such as a 401(k) or 403(b), the most important aspect of determining an investment strategy is “time horizon” and “risk tolerance.”
An action item for March encouraged readers to establish a time horizon by determining their expected retirement age. Knowing this age is essential to establishing risk tolerance, which in turn will impact decisions regarding the allocation of monies to stocks, bonds and other investments.
Because older readers have less time until they will need to use their retirement savings to offset living expenses, their risk tolerance is low and their investment strategy should be less aggressive than when they were younger. These investors should have a higher allocation to bonds because bonds are less volatile than stocks.
Younger readers investing for retirement have many decades to invest and therefore they have very high-risk tolerance and should invest their monies very aggressively. Higher risk tolerance allows investors to place more money in stocks than bonds, as stocks will provide the greatest opportunity for growth.
As a guide to how professional money managers make asset allocations for investors based upon time horizon and risk tolerance, last month’s column suggested readers review the availability of “target date funds” offered within their retirement plan line-up or by their brokerage firms.
These funds are managed with the expectation that the investor is retiring at age 65 on the date indicated in the fund’s name. For example, a “Target Date 2040 Fund” is managed in 2020 to reflect a time horizon of 19 years. Because the time horizon is so long, the manager assumes the investor has a very high-risk tolerance. A target date 2040 fund might have 90 percent of its assets allocated to stocks and the balance in less aggressive investments.
In turn, a 2030 fund’s allocation to stocks could be much less at only 75 percent in stocks.
Target date funds are a solid choice for most investors as they are professionally managed and well-diversified amongst many asset classes.
For investors who do not want to allocate all of their assets to a target date fund, and for those who are not willing to conduct the research necessary to select individual investments, there are many types of investments from which to choose using mutual funds and exchange trades funds (ETFs). While both vehicles allow you to pool your money together with other investors, there are several key distinctions:
- A mutual fund can be actively managed or passively managed (index).
An actively managed fund is supported by a management team that makes decisions about how to invest monies in the fund using proprietary research and analysis. Active managers attempt to “beat the market.”
A passively managed index fund attempts only to keep pace and mirror the market segment it tracks. The prices of mutual funds are known as the net asset value (NAV) and are updated only once per day after the stock market closes at 4 p.m. EST. Therefore, a trade placed early in the morning or late in the afternoon is priced and executed at the same amount.
- An ETF is also a basket of securities like mutual funds but is designed to offer more liquidity and trading flexibility. They are bought and sold on an exchange, much like individual stocks, and investors can make trades during normal market hours. Most ETFs track an index focused on a specific market segment and therefore returns will generally only mirror those of the segment.
Action item: Analyze which of your investments are mutual funds vs. ETFs and calculate how much money is allocated to active managers versus passive ones.
Next Month: Why invest in both active and passive managers?
Beth Stegner Peabody is CEO of Stegner Investment Associates, Inc., and a graduate of Sacred Heart Academy.
