Investing for the long term means you should own a portfolio of stocks, bonds and other types of investments. But why, and what is a portfolio, really?
First, let’s consider some of the common investments chosen by people who use a 401(k) plan at work. Many of them by default are put into mutual funds. That’s a kind of portfolio, but usually a portfolio of stocks and only stocks.
Increasingly, too, people are being placed by default into target-date funds. These are collections of mutual funds that cover a variety of asset classes, such as stocks, bonds, foreign investments and real estate, and then rebalance them.
A target-date fund is supposed to lower your risk over time by increasing the proportion of less-volatile investments.
Of course, volatility and risk are not synonyms, nor is it true that the target date you might choose for retirement is the best fit for your circumstance. But that’s where people end up.
Another way that some people are invested in workplace plans is cash, or a cash equivalent such as a money market fund.
This isn’t investing at all. It’s just saving, and usually high-cost saving, since you have to pay the plan administrator a fee and inflation is weakening the purchasing power of your money steadily over the years.
Finally, a lot of people in workplace plans are given or have a chance to buy their own company’s stock, usually at a discount. The problem here is the risk of concentration. Owning a lot of one stock is a huge risk. The fact that it’s your employer does nothing to reduce that risk.
What’s the answer? Own a real portfolio, and own it as cheaply as possible using index funds. A true portfolio will hold thousands of stocks and bonds, greatly reducing concentration risk.
It also will be diversified into a broad variety of asset classes, including the kinds of investments you find in target-date funds. However, instead of mechanically moving toward a distant date, a great portfolio is adjusted to match your personal goals and will change dynamically over time to match the material events in your life.
Finally, you will own no cash at all, or hardly any. A real portfolio rebalances periodically, investing incoming contributions and cash from dividends and interest payments as they come in.
In the end, you shouldn’t be able to say “I own that stock” or, to the contrary, “I’m in cash now.” Rather, you should be saying “I own stocks, and that means I own nearly all stocks” through an index fund and “My cash is working for me, all the time” since you stay in the market through thick and thin.
Risk is adjusted by reviewing your personal tolerance for the ups and downs — volatility — and in the context of when you actually might need your money for living expenses in retirement, whatever year that turns out to be.