During your working years, you may have the option of depositing a portion of your wages into a 401(k). You can draw on your 401(k) once you have retired, but your account may lose rather than gain value if you make poor investment decisions. Typically, 401(k) accounts contain an array mutual fund options. As with any investment, 401(k) account options expose you to a number of risks that affect both your principal and your potential earnings.
An aggressive mutual fund contains stocks and other securities that offer potential growth. You have no principal protections when you buy a mutual fund, and stock-heavy funds are more volatile than funds containing other kinds of securities. You put all of your eggs in one basket if you directly purchase stocks in one company. In contrast, a mutual fund contains an array of stocks, so you have a degree of protection because of the diversity of your holdings. You can protect yourself even further by investing in a stock fund that contains securities issued by companies in various sectors of the economy. In general, stocks issued by major long-established companies carry less risk than stocks issued by start-ups.
Many 401(k) plans include mutual funds that primarily hold foreign stocks and bonds. Securities issued in the developing world provide you with greater growth potential. On the downside, these securities are also riskier than stocks and bonds issued by more established companies based in economically stronger countries. However, despite the risks involved, foreign funds provide a measure of protection in the event of an economic downturn. If the dollar weakens, foreign holdings rise in value. Similarly, foreign assets drop in value when the U.S. economy improves and the dollar strengthens.
If a company goes bankrupt, the claims of bondholders are settled before stockholders can even make a claim on the company's assets. Consequently, bonds are viewed as more conservative instruments than stocks. Federal bonds are regarded as the safest investments in the market, while municipal bonds and corporate debt offer varying degrees of risk. Low-yield bonds expose you to inflation risk, which is the danger that inflation will cause prices to rise at a rate that out-paces the returns on your investments. You can reduce this risk by investing in Treasury inflation-protected securities -- or TIPS -- although these federal debt instruments tend to have low yields. Due to fluctuating prices, stocks actually provide you with a high degree of protection against inflation risk.
Ultraconservative investors often buy shares in money market mutual funds, which hold cash equivalents such, as short-term Treasury bills and commercial paper. Some 401(k) accounts even include principal-protected investment options, such as certificates of deposit. As with bond funds, conservative funds expose you to inflation risk. Additionally, you could lose money if a bank goes bankrupt, since CDs are only federally insured up to $250,000.
Many 401(k) plans are insured by the Pension Benefit Guarantee Corporation, which provides you with monthly payments if your 401(k) provider goes bankrupt. Money market mutual funds and other securities are often protected by the Securities and Investor Protection Corporation for up to $500,000 per account holder. The PBGC and SIPC only cover losses related to your 401(k) custodian becoming insolvent rather than performance-related losses.
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