Four Essential Principles of Investing Every Participant Should Know

Helping your plan participants understand the importance of retirement planning and how they can best accumulate assets is one of the primary responsibilities of plan sponsors. While plan participants don’t need to know every aspect of portfolio management theory, there are a few key concepts that every participant should understand:

The risk/return relationship. Risk and return are related – that concept is a cornerstone of investing. The higher the risk, the greater the potential for returns. However, that word “potential” is important. Often plan participants think that assuming more risk automatically means they will make more money, and that’s not accurate. Riskier investments tend to fluctuate more in value more than lower-risk, more stable options. So while riskier investments offer the potential for greater returns, they also offer the potential for larger losses. Each participant needs to understand his or her risk tolerance and choose a mix of investments that fits their risk profiles.

The power of compounding. Compounding is, very simply, when the earnings on investments begin to generate their own earnings. To look at a very simple example, suppose a hypothetical investor saved $20 each month in a tax-free account, and was able to earn a 5 percent return, compounded annually. After 30 years, the investor would have $16,311, even though he or she only contributed a total of $7,200. The extra $9,111 was generated by compounding.Of course, there’s something else at work here, too, and that’s time. The more time our hypothetical investor gives his or her money to grow, the greater the effect compounding will have.

Diversification. Market timing is buying and selling financial assets based on what you think the market will do. The problem is that financial markets are unpredictable, and accurately timing them is very difficult. A better alternative is to choose a diversified mix of assets, which reduces overall risk, rather than chasing “hot” investments or following trends. Diversification works because the gains of some securities help offset any losses in others. That’s why diversified investors distribute their portfolios among different investment classes, like stocks and bonds. Stock and bond markets don’t tend to move up and down together, so a mix of these investments offer better diversification.  There is no guarantee tat a diversified portfolio will enhance overall returns or outperform a nondiversified portfolio.  Diversification does not protect against market risk.

Rebalancing. Creating a diversified investment portfolio isn’t something that investors can do once and then ignore. It’s important to monitor investments to make sure they are performing properly, and to make sure that investments are still properly allocated. For example, an investor might choose to put 50 percent of his or her portfolio in stocks, and the other 50 percent in bonds, based on risk tolerance and financial goals. After several months, if stocks outperform bonds, the portfolio may have a larger amount in stocks than bonds. The investor should rebalance the portfolio to its original proportions.

As a plan sponsor, you are required to make sure your participants are properly educated about retirement planning. If you need help in developing an educational plan for your participants, contact FiduciaryFirst at 866-625-4611 or browse the rest of our website.

This information was developed as a general guide to educate plan sponsors, but is not intended as authoritative guidance or tax or legal advice. Each plan has unique requirements, and you should consult your attorney or tax advisor for guidance on your specific situation. In no way does advisor assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations.