So you’ve gotten your credit card debt under control and now have some extra income to save and invest for your retirement. Congratulations! You’ve earned the right to make some important choices that will take you closer to your goal of retiring strong. In essence, you must choose:
- What types of retirement accounts to create and contribute to. Please see our section on 401(k)’sand IRA’s for more information; and
- What types of INVESTMENTS to buy with your savings.
There are many types of investment options available and the choices can seem intimidating at first. Don’t let this intimidation keep you from putting forth a little effort to learn about investing. You will soon see that it’s not as complicated as it seems!!Saving your hard earned money year after year is a powerful way to prepare for retirement. Here is a Compound Interest Calculator that illustrates the power of compound interest with annual contributions. You can develop your own schedule of periodic contributions to your retirement investments. You can choose to contribute a set amount each paycheck, month, etc. The key is to develop a simple plan to save and invest and stick with it!
Types of Investments
Most banks offer savings accounts. You put cash in a savings account and the bank pays you an interest rate. Savings account interest rates can vary from 0.25% and up. Keep in mind that the average annual inflation has historically been around 3%. Placing all your savings into a savings account paying 0.25% will not overcome inflation. At the time of this writing, there exist internet based savings accounts paying a 5.05 annual percentage yield.
CD stands for “Certificate of Deposit.” Unlike a savings account, a CD requires you to leave your money in the CD for a set amount of time. During this time you do not have access to your money. Terms may be 1 month, 6 months, 1 year or more. In exchange for leaving your money with them, the bank will pay you a set amount of interest. Interest rates on CD’s vary from bank to bank so shop around. You do not necessarily have to have a checking account at a bank to open a CD there.
Governments (city, state, and federal) and corporations sell bonds in order to raise money. A bond is an IOU. When you buy a bond, you get a promise that the issuer (government or corporation) will pay you a set amount of money for a set period of time. Bonds are typically considered “safer” than stocks and they generally provide less potential returns.
When you buy a stock in a corporation, you own a portion of that corporation. For example, if “XCorp” has one million shares “outstanding” (meaning being traded publicly), and you buy 1 share of “XCorp,” you own 1/1,000,000 of ”Xcorp.” If you paid $10 for that share and 1 year later it is worth $11.00, you have earned a 10% annual return on your investment.
As an investment type, STOCKS as a whole have provided greater returns than CD’s, and bonds. But they are also riskier. If you put all your savings into one company and it goes out of business a year later, your savings are GONE!
To decrease your risk of catastrophic losses, one strategy is to DIVERSIFY your portfolio of investments. The principle is simple: don’t put all your eggs in one basket! If you spread your savings among several different stocks and bonds, and one of the companies goes under, you may lose some money but will not lose everything. One EASY way to diversify your investments is to buy mutual funds.
When you buy a share of a mutual fund, you buy a piece of a fund that owns multiple securities. The fund may own all stocks, all bonds, or some combination thereof. Mutual funds vary in their strategies, returns, and fees.Yes, there are fees. When you own a mutual fund, you must pay a fee to the person whose job it is to manage the fund. Fees vary from fund to fund.
Note that not all funds are created equally and some have higher fees than others. Understand that some mutual funds charge “loads.” A “load” is a fee charged when you put your money into the fund. Even “no-load” funds generally charge management fees. Fees range from a fraction of 1% of the value of your fund shares per year, to 1% or more. Some fund’s fees are higher than others so it is important to consider the negative effects of fees and loads on the performance of your investment over the long term.