Investing 101: What to Know Outside of Your 401(k) Plan

If you're ready to invest beyond your 401(k), first understand two key elements: asset allocation and diversification.

You understand why investing is important and are seeing your 401(k) grow over time, despite occasional market downturns. Are you ready to explore additional investment opportunities but not sure where to start?

Before you start picking and choosing stocks, make sure you're considering whether maximizing your contributions to your 401(k) retirement plan should come first. Also work with your financial professional to discuss whether setting up a Roth IRA is a good option. "You want to take these steps first because contributions to a 401(k), 403(b), and Traditional IRA may be tax deductible so not only do you pay less in taxes today, but your earnings can grow tax free until you take a disbursement in retirement," says Christina Fanelli-Becker, Vice President and Portfolio Manager at Regions Private Wealth Management in Tampa, Florida. "Although Roth IRA's are not tax deductible, they are tax free," she said.

Once you are comfortable that your retirement accounts are in order, you can start rounding out your investment portfolio based on your own objectives and the principles of asset allocation and diversification.

Guiding Principles for All Investors

Before diving into investing, it's important to understand asset allocation and diversification.

"Asset allocation is the way you distribute your money across a mix of asset classes. Diversification essentially means not putting all your eggs in one basket," says Fanelli-Becker. Diversification helps mitigate risk because your investments are spread across several types of investment vehicles.

The three primary asset classes are:

  • Equities (stocks)
  • Fixed income (bonds),
  • Cash equivalents (money market instruments such as certificates of deposit)

Equities: A stock is a share in the ownership of a publicly held company. There are different types of stocks with different degrees of risk: large-cap, mid-cap, small-cap, international, and others. Stocks also can be grouped by sector and industry, such as healthcare, banking, and consumer durables.

An aggressive portfolio is generally considered to be one that consists mostly of stocks and, generally speaking, can incur greater volatility and risk. "Aggressive portfolios tend to be more appropriate if you can tolerate greater risk and have time on your side to ride out market downturns," Fanelli-Becker says.

Bonds: Bonds are like IOUs. By purchasing them, you lend money to a government entity or corporation. The bond issuer agrees to pay you back with interest on a set date. As with stocks, there are different kinds of bonds, including corporate, government, and municipal. Bonds are rated so you can assess the issuer's creditworthiness.  While a good credit rating does not mean that a bond is without risk, it can help you compare different options.  "An investor can hold a core portfolio of investment-grade domestic bonds and also have exposure to high-yield and foreign bonds," Fanelli-Becker says.

If your portfolio is made up mostly of bonds and other fixed-income investments, it's typically considered conservative.

Cash Equivalents: These are lower risk assets that can be readily convertible into cash, such as money market holdings, certificates of deposit, short-term government bonds or Treasury bills, marketable securities, and commercial paper.

Expanding your Investment Portfolio

Before you start investing outside of your retirement accounts, you may need to open a brokerage account. Unlike your 401(k) and IRA, you can deposit unlimited amounts of money into a brokerage account with a licensed brokerage firm. This account allows an investor to deposit funds and place investment orders through the brokerage, which then carries out the transactions on the investor's behalf. It's important to note that a brokerage account does not have tax benefits like an IRA or 401(k).

Choosing stocks and bonds can take so much time to research that even some of the most experienced investors don't buy and sell individual stocks. Whether you're a novice or an experienced investor, mutual funds can provide an efficient way to diversify. These funds pool investor money, and professional managers determine the investment vehicles and allocation percentages within the fund.

Similarly, exchange-traded funds are another type of pooled investment vehicle professionally managed with diversification in mind.

"You can analyze whether your portfolio is sufficiently diversified by consulting your advisor periodically and also tracking the expected returns relative to the historical performance of a comparable portfolio with similar risk characteristics," Fanelli-Becker says. Always remember that past performance of any investment is no guarantee of future returns.

Your financial advisor also can review your holdings to ensure that you don't have too much of any one asset, based on your risk tolerance and goals. "If you hold a portfolio consisting primarily of mutual funds, it's important to understand the underlying assets within the funds," Fanelli-Becker cautions. "You might believe you're diversified because you hold several separately managed large-cap mutual funds, but a deconstruction analysis can reveal that the funds may overlap in the assets they hold."

Would you like to learn more about getting started with investing outside of your 401(k)? Check out this glossary of important investing terms.