Investments in securities are a very important component of a comprehensive retirement income plan. I’m defining securities as investments where you have market risk, which is the risk that your investments can potentially decline in value over a certain period of time. Like any other risk-reward trade-off, because securities have the potential to lose money, they also have a higher growth potential when compared to more conservative choices like annuities and CDs.

It’s important to consider the other pieces of your retirement income puzzle, like your Social Security amount and any annuities you own, when deciding how much to invest in securities. Being too aggressive could expose you to unnecessary risks like sequence of returns risk and interest rate risk; being too conservative could expose you to inflation risk and health care expense risk where your money is not growing fast enough to overcome the rise in prices of your essential goods and services.

There are several different types of securities that could be appropriate for a retirement income plan. I’ll detail some of the more common ones below.

When you own shares of a company’s stock, you are actually part owner of that company, however small your portion may be. Stock shares are traded in a secondary market like the New York Stock Exchange where there are potential buyers and sellers of stock shares. Based on the supply and demand of your particular stock, the market finds a price where buyers are willing to buy and sellers are willing to sell. This is a very simplified explanation of what determines the price of a stock.

So basically it’s people’s perceptions that determine the price of a stock. Their perceptions are based on that company’s revenue, profit, industry, current management, dividend, balance sheet, etc. Lots of things go into the way someone values a company, and every investor has their own criteria. Some are buy-and-hold investors for the longer term; others are traders looking for a quick profit on trading the stock. You can see then that stock prices are highly speculative and this is a big reason why they can be subject to wild fluctuations at any given time.

In other words, this is why stocks can be risky. Typically the larger and more established the company, the less volatile their stock price will be. Also industries that are more “boring,” for lack of a better word, like manufacturing and consumer staples, tend to be more conservative, where industries like technology and biotech with more cutting edge products can be more volatile. The more volatile the stock, the larger the chance for both gains and losses.

If you own stocks, you’re a shareholder in the company. But, if you own a company’s bonds, you are their creditor. Bond owners have effectively lent money to a company or an area of government like the U.S. government or to an individual state, city, or county. When companies or government bodies need to raise money, they will often issue bonds. They will set the date on when the bonds have to be paid back (maturity date), and the interest rate (coupon rate) they’re willing to pay their lender who is you, the bondholder. Generally the weaker the financial strength of the bond issuer, the lower their credit rating is, and the higher interest rate they have to pay on bonds to get investors to lend them money.

Just like stocks, bonds are also traded in a secondary market so their prices are created by perception as well. For bonds, some other factors also come into play that impact their price. The credit rating of a company is a factor, but two other main factors are interest rate movements and the number of years left til the maturity date. If general interest rates in the economy go up, then bond prices will fall, and vice versa. Think about why this is the case. If Mary just bought a bond and is getting a 4% interest rate paid to her, and now interest rates are increased by a full percentage point, Jim can get that same exact bond and be paid 5%. If Mary wants to sell her 4% bond to Jim, she has to sell it a lower price than she bought it in order to make it a fair deal for Jim.

This may make it seem like bonds are more risky than stocks, but your average bond has much less volatility than the average stock. The longer out that the maturity date is, and the weaker the credit rating, the more volatile that bond will be. The reason for this is that each of these two conditions increases the chance that the bond issuer will default, meaning not pay the bond holder back his initial investment. This has been a pretty basic overview of how bonds work, but it gives you a decent idea of what they are and how they work.

I’m going to discuss these two together even though they’re slightly different in how they work. But, in essence, they’re both funds, meaning they are both a collection of securities, often called a basket, that investors can buy all at once without have to buy one stock or one bond at a time. These funds will often include a basket of securities based on a certain theme, like large-cap stocks, energy stocks, short-term corporate bonds, high-yield bonds, etc. Sometimes funds will contain a mix of both stocks and bonds. This is a good way to achieve diversification in your securities portfolio since you can invest in many different companies or government agencies at one time.

Although ETFs and mutual funds are both priced, and bought and sold a little differently from each other, their price is ultimately based on each of the price of each of the underlying securities in the fund. Diversification is important here and having a basket of securities makes it less likely that one particular stock or bond will either make or break the fund. However, the securities in a particular fund are often ‘highly correlated,’ which means most of the securities are closely related to each other and will have similar price movements. Let’s say an ETF is made primarily up of long-term corporate bonds. If news comes out that the Federal Reserve is planning to raise interest rates when most experts were not expecting them to do so, the chances are that most, if not all, of the bonds in the ETF will go down. So the value of the ETF itself will naturally go down in price.

There are two main types of investment management styles:

This may sound like a fancy term but it simply refers to the buy-and-hold style that most financial advisors who work for broker-dealers use. An advisor using this style will often start the client relationship with a questionnaire that attempts to determine the client’s risk tolerance and time horizon for his or her investments. Then, this advisor will look in the selection of securities products that his company offers and find the right blend that best serves his client’s needs. Usually this selection is made up mostly of mutual funds and ETFs with an occasional individual stock or bond thrown in.

As time goes on, the advisor might change one or two things in the portfolio every year, but the portfolio is mostly static. You will participate during both good times and bad in the market as the portfolio stays almost fully invested. This style is generally the most appropriate for folks with quite a few years from retirement whose time-frame for needing their retirement funds is long-term. This strategy can also be appropriate for the portion of retirement assets in a holistic retirement income plan that are dedicated to longer term growth. These funds wouldn’t need to provide income until later in retirement, so they have more time to withstand the ups and downs of the market, and thus grow more over the long term.

Tactical asset allocation started to gain a lot of popularity after the serious stock market corrections in 2008 and 2009 as well as the one in the early 2000s. Some investors lost 50%, 60% or more of their portfolio and they looked for a better way to protect their investments from these massive downturns.

This style involves an advisor or money manager that is much more hands on with a client’s portfolio. Many firms known as investment advisory firms will use this style. Instead of using a static portfolio, a money manager is watching your money on a daily basis looking to rotate out of securities showing weakness and into securities showing strength. They are looking at the individual risk-reward situation of individual securities, sectors, and even the market as a whole. Said a simpler way, they are always looking to buy securities that have the best chance to increase in value, and sell securities that are likely to go down. These money managers will often have some type of algorithm, or mathematical formula, that automates most of these decisions to buy and sell.

This style tends to be more costly to use because of the increased amount of transactions and labor needed to actively manage portfolios. So, fees are usually higher with a tactical style. In years of a bull market where securities keep going up over an extended period of time, a tactical style will likely slightly underperform a strategic style. However, during times of corrections which often happen quickly and severely, a tactical style is much more nimble and able to move you out of harm’s way quicker.