It is crucial that you don't invest in something that you don't understand. Let's take some time to understand some basic investment alternatives that are commonly used when investing for retirement.
Before mutual funds came along, investors wanting to invest in a company or a few companies had to buy shares of stock in those companies. The value of the investment in a particular company is dependent upon the performance of that one company.
Average investors buying individual stocks will typically invest in just a handful of companies because the price of more established, blue chip stocks can be high. Because they own shares of stock in only a few companies, their risk remains higher than if they could own the shares of many companies.
IMPORTANT NOTE: Stock investing involves risk, including possible loss of principal.
As a 401(k) plan participant, you may have an option to invest all or a portion of your regular contribution in your company's stock. Many participants choose to put a good portion of their savings into the company's stock fund. But investing in an individual company's stock usually carries more risk than investing in mutual funds. As with all stock, your company stock may go up and down as market conditions change and the company's earnings fluctuate.
However, buying shares of company stock while also investing in other funds can substantially reduce your short-term volatility and possibly increase your long-term investment performance.
Look at your company's past performance. Past performance does not guarantee future results, but it can certainly tell you how it has done compared to other types of investments over the same time period.
IMPORTANT NOTE: Stock investing involves risk, including loss of principal.
By investing in a mutual fund, your dollars are invested in a large number of shares of many companies all at once, and your investment risk is spread out over many stocks, not just one. With mutual funds, your potential for risk is less. The ups and downs in the value of your investment are potentially less with a mutual fund than with an individual stock because you are more diversified.
Nearly all 401(k) plans offer some type of mutual funds because mutual funds provide instant diversity of investments.
Mutual funds make it easy for you to invest in stocks and bonds. There are potentially two main advantages of investing your money in mutual funds:
You can buy open-end or closed-end funds. Open-end funds issue and redeem shares based on the flow of money in and out of the funds. Open-end funds are typically what you think of when you think of mutual funds.
Each mutual fund has one or more fund managers who are skilled in the principles of money management. They also have access to a huge database of research.
Each fund also has a particular objective. That objective is defined in the fund's prospectus. The objective could be long-term growth, current income, or a combination of income and growth. For example, the objective of XYZ fund is long-term growth. To accomplish the fund's objective, the fund manager invests the money received from its shareholders by purchasing shares of many individual companies (or leaving a small portion in cash). Some stock mutual funds can own shares of stock from a few hundred companies, thereby limiting its holdings in any one company to no more than 5–6% of all the assets in the mutual fund. This is true diversification, and your risk is less than if you invested in just one or two individual stocks.
Retirement plans may use many types of mutual funds. Some invest primarily in stocks, others mainly in bonds, while still others, known as balanced funds, invest in both stocks and bonds. Some are limited to investing in securities in the U.S., while others invest in foreign securities.
IMPORTANT NOTE: The monies in your retirement plans are growing on a tax-deferred basis (or tax-free* if in a Roth); that is, the earnings are not being taxed while they are in the retirement plan. Since you're already getting a tax-deferred benefit, you may not want to invest any of your funds in tax-exempt investments. It may be better to invest in a higher yield taxable investment. In addition, stock and mutual fund investing involves risk, including loss of principal. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will likely decline as interest rates rise and bonds are subject to availability and change in price. International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
*federally tax-free, may be subject to state and local taxes
Guaranteed Investment Contracts (GICs)
A GIC, or guaranteed investment contract, may be one of the investment options in your 401(k) plan. The main reason why so many 401(k) participants have selected GICs is that GICs offer a fixed rate of return, typically guaranteed for periods up to a year or so. Also, the account value does not fluctuate with changes in market conditions, as with stocks and bonds. If the guaranteed rate is 5% for the current period, you can expect that your account will increase in value by 5% by the end of that period. While your return may only be 1–2% higher than money market funds, GICs eliminate the ups and downs associated with other fixed-income investments, e.g., government and corporate bonds.
But GICs may not be as safe as the name suggests. It's important to know the institution(s) that is (are) guaranteeing your funds. Most GICs are usually guaranteed by insurance companies, so it's important to know the financial rating of the company (they should be rated A+ or better by AM Best). Some GICs may be guaranteed by banks that are federally insured. Your employer can provide you with this information.
One more thing on GICs: They are not designed to provide you with long-term growth, as stocks are. Investing in safety is appropriate for the short-term but can jeopardize your long-term investment results.
IMPORTANT NOTE: Stock investing involves risk, including possible loss of principal. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will likely decline as interest rates rise and bonds are subject to availability and change in price. Government bonds are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor's yield may differ from the advertised yield.