The choice of investment instruments is dictated by a number of factors. Among them are age, tax bracket, family considerations and income. While many investment advisers recommend stock investments to take advantage of the ability of stocks to earn returns in excess of inflation, such judgments must also be based on the ability of the individual to absorb risk. The more important issue is for the individual to save for every important goal they have in life. It is the ability of stocks and bonds to compound earnings that makes for successful investors. As an example, a 10-year investment at 4 percent earns only 1/4 the amount of the same dollars invested at 7 percent for 20 years. The second important action is to decide how much risk to employ. The benchmark for comparison should be either the expected rate of inflation or the rate of a U.S. Treasury bond held for the same amount of time. Thus, with inflation at 4 percent, a return on stocks of 5 percent beats the rate of inflation, but is it enough to offset the riskiness or variability of the return? That is the question each investor must decide for themselves.
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Tax Deferred Retirement Accounts: Factoring in Loss of Income
The advent of the individual retirement account, along with pension funds and 401K retirement accounts, represents the largest amount of savings in the United States. Since all savings accrue pre-tax, it is an ideal factor for young savers. Taxes are not paid until retirement age is reached and income normally declines. Emphasizing the tax-deferred accumulation of funds creates an important factor for current income through bonds, money market funds, preferred stock and high dividend stocks with a history of regular dividend increases. This removes much of the risk that the amount needed will not be available, due to market fluctuations.
Diversification, an Important Factor in Dispersing Risk
Diversification among different asset classes, like bonds and stocks, is important just as investing in stable or strong currencies is important. The most important factor in risk control, regardless of the type of assets the investor deploys, is how well the investor is diversified. Diversification is a factor that improves returns and smoothes the variability of the returns.