In the previous section, we discussed how factors such as retirement target, risk tolerance, and age play a crucial role in determining the right balance of stocks, bonds, and money-market securities in a portfolio. Age, in particular, is the most significant factor as it influences the level of concern for stock market volatility. The further an individual is from retirement age, the less impact short-term market fluctuations will have on their portfolio. However, as retirement draws closer, the focus should shift from investment return to the safety of principal. Now, let’s explore the different components of a retirement portfolio, including stocks, mutual funds, and bonds.
Stocks
Stock investments offer two primary avenues for generating returns: potential appreciation in the stock’s value and dividends. When an investor purchases 100 shares of stock at $20 per share and sells them a few years later for $28 per share, they realize a gain of $800. Additionally, stocks may provide dividends, which are portions of a company’s earnings distributed among its shareholders. The amount of dividends each share pays is known as the yield, representing the rate of annual income the stock generates.
For example, if a company’s stock is currently priced at $40 per share and pays an annual dividend of $1 per share, the yield would be 2.5 percent (dividend / current price per share = yield). It’s important to note that some stocks may have relatively small dividends, and in such cases, investors may seek higher yields by allocating funds to investments with better returns. When comparing stocks within the same industry with similar qualities, the amount of dividend paid by a company can be an important deciding factor.
Here are some key points to remember about stocks:
- Common stock represents an ownership share in the company that issued it.
- Dividends are profits distributed to the company’s owners and shareholders.
- Yield is determined by dividing the current annual dividend of any stock by the share price.
Preferred Stocks
In addition to common stock, many companies also issue a special class of shares called preferred stock. Preferred stocks generally offer higher dividends than common stock but may not have the same potential for price appreciation. It’s important to remember that investing typically requires tradeoffs, where an investor must weigh different factors such as overall return, safety, or dividends for growth.
Categories of Stocks
When constructing a retirement portfolio, individuals have several stock categories to consider. These categories may overlap, and each offers unique characteristics that suit different investment goals. Here are a few examples:
- Growth stocks: These stocks are expected to grow faster than the overall economy or stock market. They typically demonstrate consistent earnings growth but may pay fewer dividends. Investors seeking capital appreciation and willing to tolerate some volatility may find growth stocks appealing.
- Blue chip stocks: Blue chip stocks are often acquired for their potential appreciation rather than income. Most large growth stocks are also considered blue chip. These stocks represent shares in industry-leading companies with highly rated financial credentials. They typically pay good, steadily rising dividends that are frequently reinvested in the company. Blue chip stocks offer stability, reliability, and long-term growth potential.
- Income stocks: Income stocks distribute a larger portion of their profits to investors through quarterly dividends. They are commonly associated with more mature, slower-growth companies. The regular dividends offered by income stocks make them relatively less risky compared to small company stocks. Investors seeking a steady stream of income may find income stocks suitable for their portfolio.
- Small company stocks or small-cap stocks: These stocks are generally riskier than blue chip or income stocks, but they also offer higher long-term average returns. Small company stocks belong to newer, fast-growing companies with significant growth potential. It’s important to remember that higher risk often comes with the potential for higher returns. Investors seeking aggressive growth and willing to tolerate higher volatility may consider small-cap stocks.
- Foreign stocks: Investing in foreign stocks can be accomplished through various foreign stock mutual funds. Including international stocks in a portfolio offers diversification and potential performance benefits. While many investors primarily focus on U.S. shares, the American market represents less than half of all global stock market opportunities. By including foreign shares, investors can diversify their investments as international markets may perform differently from the U.S. market.
By carefully considering these categories of stocks, investors can tailor their retirement portfolios to meet their specific financial goals, risk tolerance, and time horizon. Diversification across different stock categories can help mitigate risk and capture potential returns from various segments of the market. However, it’s important to note that investing in stocks carries inherent risks, and individuals should consult with a financial advisor to ensure their portfolio aligns with their unique circumstances and objectives.
In the next part of this series, we will discuss mutual funds and bonds as important components of a well-rounded retirement portfolio. Stay tuned for Retirement Portfolio: Building a Solid Foundation for Your Future (Part 3)
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