Even once you put money aside for your retired years, you also have to avoid investment mistakes that can endanger your retirement nest egg. Unfortunately, many Americans don’t know how to protect themselves against those risks, and as a result, they often take extreme positions that can lead to catastrophic consequences if things go badly.
Almost 60 percent of Americans who save for retirement using individual retirement accounts have “extreme” investment allocations, according to the Employee Benefit Research Institute. Such individuals — at both ends of the perceived risk spectrum — are thus vulnerable to common circumstances that can make them fail to achieve their savings goals. Let’s look at the EBRI research to see what the problem is and how you can solve it.
Too Risky, Too Safe, but Never Just Right
What the EBRI called extreme allocations included IRA portfolios in which 90 percent or more of the account’s assets were invested in a single category of investments. Extremely aggressive investors had all or almost all of their money in stocks, with more than a third of all IRA owners having at least 90 percent stocks. Extremely conservative investors also made up a large group of investors, with almost a quarter of those surveyed having 10 percent or less of their assets in stocks, and almost one in five IRA owners having 90 percent or more of their assets in bonds and cash. Add those categories up, and you have almost six out of 10 with extreme allocations in their IRAs.
Yet not all of the results of the study were surprising or contrary to what most advisers would recommend for clients. Those who invested in Roth IRAs were more likely to have more than 90 percent of their money in stocks, with almost half having that concentration, taking maximum advantage of the tax-free growth potential of those specialized types of retirement accounts. Moreover, as the age of the IRA owner rose beyond 55, investors were less likely to have high concentrations in stocks, reflecting the expected reduction in risk that most advisors recommend as people age. By the time IRA owners reached age 85, those concentrated in bonds and cash had almost caught up to those with massive stock allocations.
Taken in its entirety, the EBRI’s database of IRAs showed overall allocations of just over half to stocks, about 10 percent to balanced funds, 15 percent to bonds, 13 percent to cash and the rest in other types of investments. That asset allocation would put the typical IRA into a moderate to aggressive strategy, but it’s not entirely out of hand with conditions in the financial markets.
Did Investors Chase Performance?
Included in the EBRI study was a look at how the most recent data from 2012 compared with earlier studies in 2010 and 2011. Different methodologies gave different pictures of the state of the U.S. retirement saver.
Looking at the EBRI’s full sample size, investors appeared to be chasing performance in the stock market. From 2010 to 2012, the amount invested in stocks rose from 45.7 percent to 52.1 percent, while allocations to bonds and other investments fell dramatically. The shift among older Americans was most pronounced, with those 65 and older raising their stock allocations by 8 to 10 percentage points.
Yet when the EBRI controlled its database to include only those who had IRAs in all three of its survey years, it got a different picture. In this sample, equity exposure fell slightly, while bond allocations rose.
Nevertheless, more than 55 percent of those surveyed had either none of their money or all of their money invested in stocks both in 2010 and in 2012. That points to a lack of prudent risk awareness among retirement investors, as well as a failure to appreciate the value of a diversified portfolio.
How to Avoid a Big Retirement Mistake
In general, IRAs benefit from having a well-thought-out asset allocation strategy spread across different types of investments. By having stocks, bonds, cash and other investments in your IRA, you can ensure that you’re protected against major events that dramatically affect the value of one asset class yet leave others relatively unscathed. Such an approach helped mitigate losses during the most recent bear market, yet they left investors in a position to benefit from the ensuing recovery.
It’s easy to use an all-or-nothing philosophy in your retirement planning, but it’s not the smartest way to invest. By using all the various investments at your disposal, you’ll have a better chance of having things work out the way you want in the long run with your retirement savings.
Motley Fool contributor Dan Caplinger started saving for retirement early and often. You can follow him on Twitter @DanCaplinger or on Google+. To read about our favorite high-yielding dividend stocks for any investor, check out our free report.