Investing for retirement isn’t about getting rich quick or finding that “home run” stock. It is about having a disciplined savings plan that can be maintained over a long time horizon. Just as you wouldn’t expect to be able to speak a foreign language without learning the basics and practicing, investing for your retirement over the long term also takes knowledge and discipline. While there is no need to become the next Warren Buffett, you can amass a reasonable (and even significant) amount of wealth with a few basic concepts and practices.
The effect of compounding allows your money to work for you. Essentially, you are exponentially increasing savings by receiving earnings on your reinvested earnings. It’s similar to the effect of a rolling snowball.
Let’s say you invest $10,000 and that money earns a 7% annual return. At the end of the year, the $700 you earned is reinvested and added to your original $10,000 investment. You now have $10,700 invested. If you earn another 7% the next year, you would now earn $749 (7% of $10,700 rather than $10,000). After 10 years earning 7% you would have $19,671, which is almost double your original investment. Returns grow exponentially the longer you leave them in the account. For example, if reinvested over 20 years that amount would grow to $38,636 and after 30 years, the total amount would be $76,122 which is 7.5x your original investment.
The previous example was simply hypothetical to illustrate the power of compounding. In real life you would also need to account for taxes and some variability in returns from year to year. However, if you have a retirement plan through your employer such as a 401(k), in which contributions are made pretax and taxes are deferred, compounding begins to have significant effect.
As you can see, compounding provides huge upside potential when considered over a long period of time. The earlier you start the more powerful compounding can be.
More than likely you have also heard that it is important to be diversified and “you don’t want all your eggs in one basket.” But what does this really mean and how do you accomplish diversification?
Before we go into what diversification means and how to accomplish it, it is important to understand risk. We define risk as the possibility of loss. And when talking about investments, it is a function of return. Without exception, the higher the return the higher the risk, and alternatively the lower the return the lower the risk. A good rule of thumb when evaluating investments is to keep in mind that it if it sounds too good to be true, it probably is.
Asset allocation offers us a way to reduce risk through the diversification of investments. Specifically, asset allocation is the process of deciding how to spread your dollars over several categories of investments, known as asset classes. A basic allocation may include stocks, bonds, and cash.
Stocks: With stocks you are essentially purchasing ownership into a company. The price of that stock reflects what investors think the company is worth.
Bonds: Bonds on the other hand can be thought of as a loan to a company or an organization. That ‘loan’ comes with a stated interest rate and can be traded. Bonds are more of a debt or fixed income investment.
Cash: Cash could simply be cash on hand or a cash alternative like a money market fund or certificate of deposit.
Over time, we have discovered that these asset classes as a whole have certain relationships with each other. Generally stocks tend to do well when bonds are less favorable, and alternatively bonds tend to do well when stocks are performing poorly. The correlation between asset classes helps define and measure the significance of their relationship. Other types of asset classes you may be familiar with are real estate, commodities, and precious metals.
Asset allocation is important for two reasons. First, the mix of asset classes you own is a large factor, and can be argued the largest factor in determining your overall investment portfolio performance. How you divide your money between stocks, bonds, and cash can be more important than your choice of specific investments. Second, by dividing your portfolio among asset classes that don’t respond to market forces in the same way at the same time, you can help minimize the effects of market volatility while maximizing your chances of long-term return. Ideally, if your investments in one class are performing poorly, assets in another class may be doing better and may help stabilize your portfolio.
Remember that during any given period of market or economic turmoil, some asset categories and some individual investments historically have been less volatile than others. You can manage your risk to some extent by diversifying your holdings among various classes of assets, as well as different types of assets within each class.
Additionally, the appropriate asset allocation varies from person to person based on their goals, risk tolerance, and time horizon (length of time one has until retirement age). A more growth oriented allocation defined by a higher portion of stocks is generally more appropriate for someone that has a long time horizon and/or a higher tolerance for risk, where a fixed income allocation defined by a higher portion of bonds or other fixed income instruments may be more beneficial for someone that is, or is soon to be, dependent on distributions from investments (near or in retirement age).
The next step is to put your savings plan into action. It’s never too early to get started. To the extent possible, you may want to arrange to have certain amounts taken directly from your paycheck and automatically invested in accounts of your choice (e.g., 401(k) plans through payroll deduction savings). This arrangement reduces the risk of impulsive or unwise spending that will threaten your savings plan.
One of the benefits of participating in your workplace retirement plan is that you’re automatically using an investment strategy called dollar cost averaging. With dollar cost averaging, you acquire shares of an investment by investing a fixed dollar amount at regularly scheduled intervals over time. When the price is high, your investment buys less; when prices are low, the same dollar investment will buy more shares. A regular, fixed-dollar investment should result in a lower average price per share than you would get buying a fixed number of shares at each investment interval.
In addition to potentially lowering the average cost per share, investing the same amount regularly automates your decision-making, and can help take emotion out of investment decisions.
At a minimum, it is wise to save 10-25% of your income, and even more if you are older and have a smaller savings balance. However, if that number is too daunting to begin with, start with a lower percentage that fits within your budget and increase that amount as you become more comfortable. The key is to just get started!
Try to resist the impulse to change your investment strategy with every news headline or hot investing tip. Timing the market correctly is very difficult. In fact, even professionals that dedicate their lives to studying markets are rarely successful at accurately timing the market. The most successful of investors will tell you that it is best to have a well-diversified strategy that can be maintained during any market conditions, and stick to that plan for the long term.
Consistency is key. At least once a year, you may need to rebalance your portfolio to make sure you maintain the appropriate asset allocation balance. For example, if one type of asset has been very successful, it may now represent too large a share of your holdings. To rebalance your portfolio, you could sell some of an asset that’s now larger than you intended and buy more of a type that is lower than desired. Or you could keep your existing allocation but shift future investments into an asset class you want to increase.
While consistency is key, it is important to periodically review you asset allocation strategy. As we get older or circumstances change, an allocation that was once reasonable may no longer be appropriate. For example, as you enter retirement, the loss of income reduces your ability to recover from unfavorable markets and becomes a magnified risk. In that case, it would make sense to give up some investment upside in return for a more reliable stream of income.
Appropriate Savings Tools
Employer-sponsored retirement plans like 401(k)s and 403(b)s are powerful savings tools. Your contributions come out of your salary as pretax contributions (reducing your current taxable income) and any investment earnings grow tax deferred until withdrawn. Some 401(k), 403(b), and 457(b) plans also allow employees to make after-tax “Roth” contributions. There’s no up-front tax advantage, but qualified distributions are entirely free from federal income taxes. In addition, employer-sponsored plans often offer matching contributions, and may be your best option when it comes to saving for retirement.
IRAs also feature tax-deferred growth of earnings. If you are eligible, traditional IRAs may enable you to lower your current taxable income through deductible contributions. Withdrawals, however, are taxable as ordinary income.
Roth IRAs don’t permit tax-deductible contributions but allow you to make completely tax-free withdrawals under certain conditions.
If you have maxed out savings to tax-advantaged accounts, consider other taxable investments. Current lower capital gains tax rates make taxable investment accounts more attractive for retirement planning.
A Professional Financial Planner
Understanding the basics is a good first step to formulating a successful investment strategy. Unfortunately, individual circumstances can make it difficult to develop a one size fits all solution. A professional financial planner can as act as a guide and resource to help you:
Understand all the investment options available to you and assist in the selection of investments that are appropriate for your goals, risk tolerance and time horizon.
Determine your retirement income needs and design a personalized strategy to help you meet those needs.
Provide a framework from which you can evaluate alternatives and make decisions best for you and your family.
In closing, each person’s individual financial situation requires personalized investment strategies. Reilly Financial Advisors is an independent Registered Investment Advisor, providing professional guidance to those still accumulating their wealth. Contact us to learn more about how a dedicated team of professionals can help you both define and achieve your individual financial goals.