Playing debt instruments and making equity investments

Debt and equity instruments are the two types of investments you use to make money with your money.

When you invest in a debt instrument, such as a bank certificate of deposit (CD), you essentially loan money to an entity for an agreed-upon period of time. In return, you receive interest payments, and you get your principal (initial investment) back at the end of the term (maturity).

Debt instruments also include bonds and money market securities. They’re often referred to as fixed-income investments because the amount you earn is fixed and predetermined. The two main investment risks that you face with debt instruments are as follows:

• Whoever you loan your money to can default on the loan — in other words, miss interest payments and/or not pay back your principal. In this case, you lose money. Bonds run the spectrum from what are considered the safest (short-term U.S. government bonds) to the most risky (high-yield or junk bonds, issued by corporations with low credit ratings). The interest paid on a short-term government bond is less than that promised on a junk bond because the government bond is less risky. But the likelihood that you’ll see your principal again is much higher with a government bond than with a junk bond. Agencies such as Standard & Poor’s and Moody’s give credit ratings for bonds issued by companies (corporate bonds).
• You may not get the full price back if you try to sell bonds before the maturity date. The essential thing to remember is that longer-term bonds are more volatile than shorter-term bonds if you try to sell them before they mature.

Equity refers to the stock market. When you put your money in equity investments, you’re buying a piece of a company. The amount you gain or lose depends on how well or poorly the company does.

Unlike debt investments, equity provides no specified interest or payment.

With equity investments, the main risk is that the company you invest in will do poorly or even go bankrupt. In the first case, the value of your investment goes down; in the second, you may lose all your money. On the other hand, if the company does phenomenally well, so does your investment. That’s why equities are generally considered more risky than fixed-income investments. However, the potential rewards (investment gains) of equities can be bigger than with fixed-income investments.

If a stock investment loses value, it’s often referred to as a negative return rather than a loss. Technically speaking, it’s not really a loss unless you sell the stock. If you hold onto the stock, its value may go back up over time, and you will have lost nothing. However, holding on to a stock and waiting for this to happen may be a bad idea, depending on the stock.

Taking a dip in the mutual fund pool

Mutual funds are a common investment option in retirement plans. When you invest in a mutual fund, your money is pooled together with that of many other people and invested under the direction of a professional money manager or in line with an index.

Mutual fund investments in your 401(k) may include the following broad categories:

• Money market funds
• Bond funds
• Stock funds (U.S. and international)

Your 401(k) may also offer a stable value fund, which is a different type of fixed-income investment similar to a bond mutual fund.

I explain these types of investments (and more) in Chapter 13. For this chapter, what you need to know is that the different categories of funds carry different levels of investment risk and expected return. In general, money market funds are the least risky and historically have had the lowest return, while stock funds are the most risky and historically have had the highest return over long periods of time, such as 10 to 20 years. (Investing is all about trade-offs!)

Because of the large pool of investor money, mutual funds can invest in a number of different investment vehicles, which is known as diversification. Diversification benefits you by lowering your overall risk. (Read more in the “Diversifying for fun and safety” section later in this chapter.)

Watching the return of the mummy … er … money

Participants often ask what return to expect on their 401(k) or IRA. That’s a great question, and I wish I could answer it definitively — but I can’t. Why? Because the return on your investments depends on a number of factors. I can provide guidelines based on past results of different investment types and generally accepted figures. These are long-term averages based on past performance; you can't assume that your investments will turn in exactly the same return or that they'll have the same return year in and year out, because they won’t. The return will fluctuate. For example, it’s reasonable to expect stocks to return an average of 9 percent over a period of about 20 years or more, but it’s not reasonable to assume that this will occur over shorter periods such as five years. Historically, stocks have periodically produced a much higher or much lower return during shorter time spans.

Investment returns over the long term, meaning 20 years or more, depend on the type of investment:

• Money market funds depend on how high or low current interest rates are. These rates have been historically low over the last ten years, so returns in these funds have ranged between 0.05 and 1.0 percent during this period.
• Bond funds vary depending on the duration you select — short-term, intermediate, or long-term — ranging from 1.5 to 6 percent.
• Stock funds can be expected to return around 9 percent but will vary substantially depending on market activity, such as the major downturn in 2008.

Because you’ll probably hold a combination of investments, the highest overall return for your account as a whole likely won’t exceed 7 percent — and it may be that high only if you’re holding at least 75 percent in stock investments. If your investment strategy is more conservative, you can reduce your expected return to 5 to 6 percent (even lower if you’re really conservative).

The robust stock market performance since 2008 has been great, but that has probably created unrealistic expectations. Stock returns have been in the 10 to 15 percent range during the last ten years but aren’t likely to do as well during the next ten years. Returns in this range should never be built into your retirement planning. (Note: The impact of the COVID-19 pandemic was too brief to have a lasting effect on the market due to the huge influx of money by the Fed.)

Diversifying for fun and safety

The best way to reduce your risk of loss, whether you invest in bonds, stocks, or other investments, is to diversify your investments — in other words, spread your money around. That way if one investment does badly, the others may do well and make up for the loss. Also, if one investment does extremely well, you’ll benefit.

Here’s an example of how it can pay off to put your money in a combination of different investments:

Manuel and Sophia both have $5,000 in their 401(k)s. Manuel chooses to invest his entire balance in a “safe,” stable value fund with an average return of 2.5 percent a year. Sophia decides to diversify her 401(k) money by investing $1,000 in each of five different categories. Her first investment choice fails, and she loses the entire $1,000 — a scenario that isn’t likely, but I use it to prove a point regarding the benefit of diversifying. Sophia’s second option doesn’t do well, and although she doesn’t lose any money, she doesn’t make any either. Her third, fourth, and fifth investment choices have average to above-average returns.

After 25 years, Manuel has $9,270 ($5,000 at 2.5 percent return for 25 years). Sophia, however, has $22,070. How did she do it? Table 14-1 shows the comparative returns.

If Sophia had invested her entire account in the first option, she would’ve lost everything. By spreading her money over different investments, she overcame that loss and even ended up making more money than Manuel did.

The most efficient way for most 401(k) participants and IRA investors to diversify is through collective investment funds such as mutual funds and exchange-traded funds, or ETFs. Mutual funds and ETFs invest in a number of different companies or other investments. Some are run by professional money managers who decide what investments to hold. Some mutual funds and ETFs are index funds, meaning that they hold most or all the same stocks in an index such as the S&P 500 (which contains 500 of the largest companies in the United States). The manager doesn’t pick stocks for index funds. The other types of mutual funds and ETFs are actively managed funds in which the fund manager buys and sells stocks in order to try to get a better return than with an index.

It can be useful to own a mutual fund or ETF. Say you buy shares in a mutual fund that owns only stocks. The value of that fund can conceivably increase on a day that a single stock drops by 30 percent if the fund doesn’t own that stock. Even if your fund does own this particular stock, your account value may drop by only a few percentage points for the day — compared to 30 percent for a person who owns only this one stock.

It’s usually not enough to own just one mutual fund unless it is a TDF or similar fund that includes a broadly diversified range of stocks and bonds. I explain how to put together a good combination in Chapter 13.

The smartest people in the investment business incur major losses when the market collapses even when they hold widely diversified investments. I know this is scary, but the only way to avoid investment risks is to not invest any money — not a good option. Keep in mind that major market downturns generally aren’t a big problem for younger investors who have many years to continue investing.

Seizing the opportunity of a downturn

I remember telling the younger members of a group of 401(k) participants during the 2008 crisis that they should be celebrating because their chances for getting a 50 percent positive return during the next five years had become much better as they can buy many more fund shares at reduced prices. I encouraged them to keep investing as much as they can afford into the plan, which is what younger investors should do when there’s a major market downturn.

As one example of how investing during a downturn can pay off, Table 14-2 shows the result of an annual $1,000 investment on January 1 of each year in Vanguard’s 2040 target-date fund (TDF).

In 2008, the fund lost more than 35 percent of its value, but the table shows that continuing to invest pays. If you still have years to invest, there’s no need to panic when big market drops occur.

One of the benefits of Target Date Funds is that they keep your stock allocation balanced by periodically rebalancing and also by reducing the percentage of stocks in your account as you get older.

Buying more when prices are low

When you invest a specified amount at regular intervals, as you do with automatic 401(k) contributions or automatic IRA deposits from your paycheck, you use an investment strategy called dollar cost averaging. (You didn’t know you were that smart, did you?) This investment strategy may lower the average price that you pay for your investments. How? Because you’re spending the same amount each time you invest, you end up buying more shares of your investments when prices are low and fewer shares when prices are high. By averaging high and low prices, you reduce the risk that you will buy more shares when prices are high.

Of course, if stock prices only go up for the entire time you invest, this strategy won’t work. But if you contribute to a retirement account over a long period of time, there will likely be periods when prices go down.

Continuing to invest new contributions when stock values drop also helps because you accrue new shares at a reduced price. Everyone likes buying things at a discount, which is what you can do when stock prices drop a lot.

Losing more than you can stand

No one wants to lose any money, but folks are especially fearful of losing more than they can afford. You probably won’t lose everything in your 401(k) account, but losing to the point of severe pain is a very real possibility (especially if you don’t diversify your investments).

The amount of risk you can take depends to a large extent on how soon you’ll need your money — your time horizon. If you won’t need the money for 20 or 30 years, it doesn’t matter if the stock market goes into a slump for a few years. Historically, the market has always recovered, so if you hold on to your investments, they’ll probably rebound (provided that you had a good reason to buy them in the first place).

If you’ll need your money in five years or less, however, you may not have time to recover from a drop in the stock market. This is when you need to move some of your money out of high-risk investments and into more stable investments that safeguard your principal, such as money market funds, stable value funds in a 401(k), and shorter-term bonds.

Older participants are in a much different position than younger ones during a strong market downturn. If you’re 60 years old and have a $250,000 account balance, having it drop to $125,000 is horrible because you don’t have that many years to continue investing. You won’t be buying a lot of shares at a discounted price. Such losses have occurred in the past because older 401(k) and IRA investors have benefited by having the stock portion of their accounts achieve great returns. As a result, participants approaching retirement age often have larger portions of their accounts invested in stocks than at any other time they have been 401(k) or IRA investors. Excess exposure to stocks has resulted in 50 percent losses in retirement holdings.

A common mistake 401(k) investors made during the late 1990s was putting too much into certain stocks that were doing extremely well such as computer and software producers instead of diversifying their investments. (They may have thought that they were diversifying by buying a high-tech mutual fund instead of stock in a single company, but that didn’t help when the entire industry bubble burst.) When those companies’ performance began to suffer, many portfolios lost a lot of value. After the dot-com bubble burst in 2000, younger investors picked themselves up, dusted themselves off, and started all over again with diversified portfolios. But investors within a few years of retiring had a completely different outlook. Many had to delay retirement.

Even if you put together a portfolio that contains good, solid performers, you’re at the mercy of general economic conditions. This type of risk is known as systematic risk, or market risk. It’s the risk that your investments will decline in value simply because current economic conditions are making most investments decline in value. These general declines have happened periodically over history and will happen again. You need to look carefully at your investments. If you decide that your investments are the right ones for you, hang on and ride it out. Historically, the stock market has always recovered, although sometimes it can take a few years. If you’re an investor nearing retirement, be sure to have enough of your investments in less risky securities that’ll keep your principal intact in case you need to tap it.

Losing your entire investment

The stock market slump that began in 2000, combined with the Wall Street collapse in 2008, caused many people to worry about losing all their retirement savings. Some workers want to know if they should pull their 401(k) money out of stocks and invest in something safer during such times.

Before you do something rash (such as pull all your 401(k) money out of stocks), you need to understand that there’s no such thing as a completely risk-free investment. Even if you bury your money or hide it in your mattress, your dog can still dig it up and eat it for lunch, or the money can be stolen. Even the investments most people consider completely safe — FDIC-insured bank savings accounts and certificates of deposit (CDs) — are only guaranteed to a certain point. They still carry some risk of loss.

The FDIC (Federal Deposit Insurance Corporation) is federal government insurance that protects your money up to a certain amount ($250,000 per person as of 2021) should the bank where you parked your money in a savings account go bankrupt. Not all financial institutions are FDIC-insured. Mutual funds are never covered by the FDIC. What’s more, the FDIC doesn’t have enough resources to back its guarantees in a total economic collapse.

The important fact is that you’ll probably never lose all your money, even if it’s all invested in stocks. One important exception is if you have too much invested in your own company’s stock or any other single stock. This type of investment can be a ticket to either riches or rags, as I explain in the next section.

Owning too much company stock

A number of 401(k) investors face the very real risk of holding too much stock in their employer’s company. Company stock may be available in a number of ways:

• Your employer can use it to make matching contributions to your account.
• Your employer can give it to you as an additional contribution.
• Your 401(k) may offer it as an investment option for your own contributions.
• Your employer may give you the opportunity to buy stock via a stock purchase plan.

Employers who contribute company stock to a 401(k) as a matching contribution or other contribution may place restrictions on when you can sell that stock — you may only be able to sell it when you turn 55, for example. This restriction puts you in a difficult situation because you won’t be able to diversify that part of your account even if you want to. In this situation, remember two things:

• Your other investments need to balance out the fact that you have so much invested in your company’s stock.
• Don’t increase your holdings by investing your own contributions in company stock.

The second point is very important. The fact that many companies prospered throughout the 1990s, and their stock values consistently increased, led a number of employees to invest some or all of their own contributions in company stock. Just how bad an idea this is became apparent in 2000, when the stock market began to decline and many investors lost big chunks of their retirement accounts. The old adage about not putting all your eggs in one basket can’t be more true.

Yes, it can be hard not to invest a lot in your own company. After all, you work there, and you want to support the company, as well as feel that you have an ownership stake in how well it does. What’s more, you may have gotten a big sales pitch from senior management on the benefits of owning company stock. Many senior managers want employees to own as much company stock as possible. Interesting psychology is at work here. According to at least one study, 401(k) plan participants who receive a matching contribution in company stock are more likely to also invest their own contributions in company stock if such an option is available in their plan. So, if your company matches your contribution in stock, you’re more likely to direct your own contributions into company stock, when really, the rules of diversification dictate that you should put your own contributions somewhere else.

Not to be ignored is the possibility that your buddies at work may laugh at you for investing your money in mutual funds when they’re making a ton of money investing in company stock. The pressure to not miss out on this “once-in-a-lifetime opportunity” can be great. One solution: Ignore your buddies.

If your employer gives you company stock, you certainly shouldn’t look a gift horse in the mouth. Take it! But think twice before you invest your own money in company stock. The risk of a major loss is simply too high. Many large, well-known companies watched their stock prices drop by more than 50 percent during the market downturn that began in 2000.

Every stock’s value goes down at some point — it seems to be only a question of when and by how much. It’s virtually impossible for a stock to only go up for 20 years or more.

Unfortunately, many 401(k) investors with a lot of company stock learned this lesson the hard way, at the worst time — in their 50s and nearing retirement. For years they saw the value of their accounts grow as they rode the company stock rocket. Then, seemingly overnight, they watched much of what they had gained flame out and disappear.

A single stock has much more potential to move up and down than a diversified collection of investments. Keep your ownership of company stock at the lowest level permitted by your plan in order to avoid unnecessary risk. This type of risk is called company risk or unsystematic risk, and the only way to reduce or eliminate it is to diversify your investments.

Not having enough money to live on during your retirement

Considering the risks outlined in the previous sections, you may wonder why investing your money in anything other than a relatively safe bank savings account is even necessary. The answer is that you need to beat inflation, the gradual rise in prices over time. You may be able to avoid many investment disasters, but inflation isn’t one of them.

If prices rise by an average of 3 percent a year, your money will lose more than 60 percent of its value over 30 years. This means that the $100,000 you have today will be worth only $40,000 when you need it at retirement 30 years from now. This loss is just as real as waking up tomorrow morning to find that your account value has dropped by 60 percent. Ouch!

You have to invest your retirement funds — it’s the only way to beat inflation.