Your employer-sponsored retirement savings plan is a convenient way to help you accumulate money for retirement. Using payroll deductions, you invest for the future automatically, following that oft-noted advice to “pay yourself first.” But choosing to participate is just one important step. Another key to making it work for you is managing risk in your portfolio. Following are five ways to tackle this important task.
1. Know your personal risk tolerance
Gauging your personal risk tolerance–or your ability to endure losses in your account due to swings in the market–is an important first step. All investments come with some level of risk, so it's important to be aware of how much volatility you can comfortably withstand before choosing investments.
One way to do this is to reflect on a series of questions, such as:
- How well would you sleep at night knowing your retirement portfolio dropped 5%? 10%? 20%?
- How much time do you have until you will need the money? Typically, the longer your time horizon, the more you may be able to hold steady during short-term downturns in pursuit of longer-term goals.
- Do you have savings and investments outside of your plan, including an emergency savings account?
Your plan's educational materials may offer worksheets and other tools to help you gauge your own risk tolerance. Such materials typically ask a series of questions similar to those above, and then generate a score based on your answers that may help you choose appropriate investments.
2. Develop a target asset allocation
Once you understand your risk tolerance, the next step is to develop an asset allocation mix that is suitable for your savings goal while taking your risk tolerance into consideration. Asset allocation is the process of dividing your investment dollars among the various asset categories offered in your plan, generally stocks, bonds, and cash/stable value investments. If you're a young investor with a hardy tolerance for risk, you might choose an allocation composed heavily of stocks. On the other hand, if retirement is less than 10 years away and you fear losing money, your allocation might lean more toward bonds and cash investments.
3. Be sure to diversify
Even the most aggressive investor can potentially benefit from diversification, which generally means not putting all your eggs in one basket. Let's take one example from above: Although that young investor may choose to put a large chunk of her retirement account in stocks, she should still consider putting some of the money into bonds and possibly cash to help balance any losses that may occur in the stock portion. Even within the stock allocation, she may want to diversify among different types of stocks, such as domestic, international, growth, and value stocks.
4. Understand dollar cost averaging
Your plan also helps you manage risk automatically through a process called dollar cost averaging (DCA). When you contribute to your plan, chances are you contribute an equal dollar amount each pay period, which then purchases shares of the investments you have selected. This process–investing a fixed dollar amount at regular intervals–is DCA. As the prices of the investments you purchase rise and fall over time, you take advantage of the swings by buying fewer shares when prices are high and more shares when prices are low–in essence, following the old investing adage to “buy low.” After a period of time, the average cost you pay for the shares you accumulate may be lower than if you had purchased all the shares with one lump sum.
Remember that DCA involves continuous investment in securities regardless of their price. As you think about the potential benefits of DCA, you should also consider your ability to make purchases through extended periods of low or falling prices.
5. Perform regular maintenance
Although it's generally not necessary to review your retirement portfolio too frequently (e.g., every day or even every week), it is advisable to monitor it at least once per year and as major events occur in your life. During these reviews, you'll want to determine if your risk tolerance has changed and check your asset allocation to determine whether it's still on track. You may want to rebalance–shifting some money from one investment to another–to bring your allocation back in line with your target. Or you may want to make other changes in your portfolio to keep it in line with your changing circumstances. Such regular maintenance is critical to help manage risk in your portfolio.