How to Invest Money in Your IRA or 401k Retirement Account
Money Girl answers listener questions and explains how to invest money in your retirement account, so you take the right amount of risk and reach your financial goals.
Once you open up a retirement account at work or on your own, the next step is to pick your investments from a menu of options. For many people, this is the toughest part because the menu might as well be written in Greek!
In this episode I’ll answer two questions from Money Girl podcast listeners and explain exactly how to invest money in your retirement account. You’ll know which investments to pick so you feel comfortable and reach your financial goals.
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It’s a common dilemma to feel confused about how to invest money in a retirement account. Maybe you can relate to Brianna C., who asks:
I’m interested in enrolling in the 401(k) at work but am very confused about the different types of available funds. How do I know what’s right for me?
Or Mina A., who says:
I’m a big fan of your podcast and decided to take your advice and open a Roth IRA. But now I’m not sure how to invest so I take as little risk as possible. What’s the next step for a beginning investor?
I’m glad these podcast listeners are being thoughtful because the retirement investments you choose are very important. They determine the rate at which your account can grow, the amount you’re likely to accumulate for retirement, and how much income you’ll be able to withdraw in the future.
Your investment options always depend on your retirement plan provider at work or the company where you opened a traditional or Roth IRA. If your company offers automatic 401k or 403b enrollment, there’s typically a default investment that’s preselected for you. You can stick with it or move your money into other plan options.
See also: 7 Pros and Cons of Investing in a 401k Retirement Plan at Work
What Is Investment Risk Tolerance?
In order to know what investments you should buy, first consider your risk tolerance. This is how you feel about risk and react emotionally when your investments decline in value.
If temporary investment losses (or even just the thought of losses, if you’ve never invested before) make you extremely anxious or cause you to lay awake with worry all night, you’re probably somewhat risk-averse. That means you don’t like taking risk even if you’re missing out on making more money.
On the other hand, if you stay cool as a cucumber and have confidence that your declining investments will bounce back before you need to spend the money, you’re probably suited to holding more risky investments.
Here’s the rub: If you invest very conservatively, you aren’t likely to lose money, but you won’t earn much either. On the other hand, if you choose risky investments, you can make a high return, but you may also lose money—especially in the short term. So most of us fall somewhere in the middle of that risk scale.
See also: 8 Tips to Invest Without Too Much Risk
How Much Investment Risk Should I Take?
When considering how much investment risk you should take, keep in mind your retirement goal, the amount of time you have to achieve it, and your potential future income.
For instance, if you want to amass a huge nest egg, have a long time before you’ll need to spend it, and have steady income, you may want to invest more aggressively. If you have at least 10 years to go before retirement, you have plenty of time to recover from temporary market downturns along the way.
Consider this: If you invest $500 a month for 30 years at an average return of 3%, your balance will grow to about $250,000. Investing the same amount over 30 years at a 10% return would give you over $1.1 million, a difference of $850,000 to spend in retirement!
Now, I’m not encouraging you to take more risk than is absolutely necessary to reach your goal. However, in order to reach an expensive goal like retirement, you can’t invest too conservatively because you’re likely to fall short.
As you get closer to retirement, it’s wise to shift a larger percentage of your investments into less risky investments so you preserve your account and can get regular income from it. I’ll tell you how to do this in just a moment.
See also: 5 Best Investing Tips to Make More Money
How to Invest Money in Your IRA or 401k Retirement Account
The investments that I recommend you buy for your retirement account are funds, such as mutual funds, index funds, and exchange-traded funds.
Funds are simply a mix of individual investments (such as stocks and bonds), which can be designed to meet a variety of investment objectives. Funds give you built-in diversification, which is less risky than handpicking individual investments on your own.
In general, stocks are the riskiest investments because their value can change daily; however, they offer the highest returns. Bonds are less risky because they offer a fixed, but lower return. And cash or cash equivalents, such as money market funds, give you the lowest, but safest returns.
I recommend that you start by figuring out how much stock you should own. Here’s an easy shortcut: Subtract your age from 100 and use that number as the percentage of stock funds to own in your retirement portfolio.
For example, if you’re 40, you might consider holding 60% of your portfolio in stocks. If you tend to be more aggressive, subtract your age from 110 instead, which would indicate 70% for stocks. But this is just a rough guideline that you may decide to change.
You might allocate your stock percentage to a variety of stock funds or put it all into one stock fund. The remaining amount would be in other asset classes such as bonds and cash, which I’ll cover.
To grow your money without taking unnecessary risk, it’s important to diversify your investments across broad asset categories, such as stocks, bonds, and cash, in a ratio that’s right for you.
Free Resource: Retirement Account Comparison Chart (PDF download)
To grow your money without taking unnecessary risk, it’s important to diversify your investments across broad asset categories, such as stocks, bonds, and cash, in a ratio that’s right for you.
Here are 5 types of funds that might be available on your investment menu:
Fund Type #1: Stock Funds
Stock funds typically make up the majority of your investment choices. They’re made up of a variety of individual stocks, which are ownership shares in different companies. Stock funds might focus exclusively on international, domestic, large, small, or growing companies, for instance.
Additionally, You might see the terms large cap, mid cap, and small cap in the names of stock funds. Cap is short for market capitalization, which is the value of a company’s stock shares. So a large cap fund means that it invests in the big boys, like Apple, General Electric, and Walmart.
Fund Type #2: Target Date or Retirement Funds
More investment menus are including target date or retirement funds, which are highly diversified, one-size-fits-all solutions. You’ll know them because they include a year in their name, such as Retirement 2030 Fund or Retirement 2055 Fund.
The date in the name is supposed to match the date you want to retire. So figure out the year when you anticipate retiring, such as the year you’ll be 65 years old, and choose the fund with the closest target date.
Target date funds include a mix of asset classes, such as stocks, bonds, and cash, so you only need to own one of them. What’s unique is that they automatically rebalance the ratio of risky and conservative investments over time, so you become less aggressive as you approach your desired retirement date.
In other words, the right amount of stocks is already baked into the product and decreases slowly as you get closer to retirement. That makes choosing a target date fund a really easy way to invest, especially for beginners.
So if Brianna has a target date fund on her 401k menu, that’s what I’d recommend for her to get started. You can always change your investment choices later on if you want to tailor them.
Fund Type #3: Balanced or Blended Funds
Balanced or blended funds are similar to target date funds in that they include a mix of stocks and bonds. However, the mix remains fixed and never changes or rebalances over time.
As I previously mentioned, if you’re a young or middle-aged investor, it’s likely that stocks should make up a majority of your retirement portfolio. Therefore, if a balanced fund is made up of 50% stocks and 50% bonds, it may be too conservative for you and wouldn’t grow your money fast enough.
Or the split could also be something like 60% stocks and 40% bonds. So, look carefully at the ratio of assets to make sure it’s right for your age and risk tolerance.
Fund Type #4: Fixed Income or Bond Funds
Your investment menu should include some amount of bond funds, which might also be called income or fixed-income funds. They’re primarily made up of individual bonds, which are loans given to a company or a government entity for a set return.
While the value of a bond fund can go up or down, its main objective is to provide income or a steady cash flow to investors. Bond funds won’t offer much investment growth, but they do protect you from losses.
If you’re a young or middle-age investor, you should own some amount of bond funds in order to temper the risk of stock funds. However, owning too much could make your portfolio too conservative to reach your retirement goals.
Fund #5: Money Market Funds
The most conservative option you’re likely to find on an investment menu is a money market fund. They’re nearly as safe as a bank deposit or CD and may give you returns of about 1% per year.
Mina asked how to invest with as little risk as possible, and this is it. However, as I mentioned, the purpose of investing is to make your money grow so you can achieve your goals. If you want to accumulate a million dollars for retirement, but are only willing to take a level o f risk that pays 1% per year, you’ll need to invest about $2,400 a month to get there.
In fact, earning just 1% isn’t even enough to even keep up with the annual rate of inflation, which has been about 3% historically. In other words, if your investments are earning about 3% or less, you’re actually losing purchasing power over the long term.
So don’t choose a money market fund for your entire retirement portfolio unless you’ve already achieved your retirement goals and just need a safe place to park your cash.
Learn more about the pros and cons of different types of retirement accounts, click here to download the free Retirement Account Comparison Chart.
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About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.
