Choosing Your Retirement Plan Investments: Understanding Risk Tolerance Levels
A 401(k) or similar retirement plan can be an incredibly useful tool for workers looking to save for retirement without the intimidation that can come with solo exploration of the open stock market. However, when it comes to investing, there is always risk involved because of the ever-changing nature of the economy—just how much risk you are willing to take on will likely depend on your goals. An employer-sponsored plan can offer a more guided experience for first-time investors, but it’s important to explore your options to gain an understanding of how tolerant you are to risk and use that information to make decisions about how you want to save in your retirement plan.
What is risk tolerance?
Your risk tolerance relates to your comfort with fluctuations or volatility in your savings, or how much change you are willing to experience throughout your savings journey. While over time 401(k) savings tend to grow, it’s a long-term strategy—and depending on the type of investments included in your portfolio, your savings may be more or less impacted by shifts in the marketplace. Of course, you’re saving in a 401(k) plan with the hopes of nurturing your nest egg to protect and finance your future, however, there are a variety of factors that can play a role in helping you to decide what level of risk will help you to meet your goals.
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An important part of any retirement savings strategy is diversification, or spreading your investment dollars across a range of asset classes and risk levels. Diversification of your assets keeps you from putting all your eggs in one basket, which can make you more vulnerable to losing a larger portion of your savings during a market downturn. The more tolerant you are to risk, the larger percentage of your complete portfolio will be in the higher risk category and, as a result, will be subject to more dramatic fluctuations. The less tolerant you are to risk, the more your portfolio should be made up of lower risk investments. There are several different types of investments that may be available to you through an employer-sponsored plan, understanding all of your investment options and may take some education and time.
Four questions that may help you determine your investing risk tolerance:
- Are you willing to take on above-average risk to get above-average potential returns?
- How anxious do you feel about the potential to lose money in the stock market?
- Would you be tempted to sell your investments if they lost money over the course of one year?
- How many more years do you plan on working before you retire?
Why would I choose to invest where there is higher risk?
With added risk, or increased chance of volatility, also usually comes the potential for more growth. Most often, the riskier investments like stocks have a chance at experiencing more frequent and dramatic changes in value (which can be either positive or negative). Younger savers who have many years before their intended retirement date stand to benefit most from investing where there is higher risk. Not only will potential growth have the largest impact and overall benefit for younger savers, but there is more time for them to make up for any unexpected downturns in the market that may impact their savings journey early on.
Who should choose a lower risk investment strategy?
While any person with a low tolerance for risk could consider a less aggressive investment strategy, a common reason a saver might consider focusing on lower risk investments is not having as many years to recoup for volatility in the market before reaching retirement. In fact, many professionally managed model portfolios and target date funds are set up to automatically decrease the percentage of higher risk investments as savers get closer to retirement. This is a common strategy for retirement savings portfolios because upon reaching retirement age, savers are more likely to begin taking distributions from their retirement funds to cover living costs post-career. During this time, you’re likely to aim for stability in your portfolio, sacrificing potential growth for increased confidence in the value of your portfolio being maintained over the long-term.
Short-term vs. long-term investing
It’s important to remember that a 401(k) or similar type of retirement plan is a tool designed to support your goals for retirement readiness as you make the choice to save and invest over a long period of time. The stock market naturally ebbs and flows, and investors with a short-term mindset who withdraw money ahead of retirement age will have to pay applicable taxes on any 401(k) distributions, plus, potentially, an additional 10 percent penalty. Long-term investment options like those you find in your 401(k) plan are designed to withstand changes in the market and your tax-deferred contributions offer an incentive to leave the money to earn interest and grow over the length of your career.
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However you choose to invest, it’s important to remember that the earlier you begin saving, the more time that your savings have to grow and compounding interest to accumulate and work its magic. Small contributions made at a younger age are worth more than larger contributions made years down the road, so maintaining a long-term mindset is key to making the most out of your plan. Of course, there are other 401(k) plan features that can help you reach your savings goals, like employer matching or profit share contributions, but consistent contributions throughout your career are the best way to bolster your chances of reaching retirement with the savings you need to live comfortably post-career.
Using your risk tolerance to choose your retirement investing strategy
While aggressive saving strategies and funds can be a great fit for younger investors, you may also simply prefer to invest where there is a lower risk for volatility. It’s up to you! What matters is that your personal risk tolerance and your goals for the future should align and make you feel comfortable. You don’t want to be losing sleep over the day-to-day changes in the stock market, so it can be a good idea to discuss your plans for the future with a financial advisor to better understand how to make the most of your retirement plan.
Check out our Retirement Saving Resources for more helpful tools to assist you in reaching your retirement goals or learn more about the various retirement plan options available through Ascensus.