Why is it important to invest your retirement savings wisely?
When people say, “I’m not an investor,” it’s often because they worry about the potential for market losses. It’s true that investing involves risk (e.g., investment losses) as well as reward, and investing is no guarantee that you’ll beat inflation or even come out ahead. However, there’s also another type of loss to be aware of: the loss of purchasing power over time. During periods of inflation, each dollar you’ve saved for retirement will buy less and less as time goes on.
Anyone who has a savings account probably understands the basics of compounding: The funds in your savings account earn interest, and that interest is added to your account balance. The next time interest is calculated, it’s based on the increased value of your account. In effect, you earn interest on your interest.
Compounding works similarly over time with investment earnings. Let’s say you invest $5,000 a year for 30 years (see chart). After 30 years you will have invested a total of $150,000. Yet, assuming your funds grow at exactly 6% each year, after 30 years you will have over $395,000 because of compounding.
The benefits of saving in an employer-sponsored retirement plan.
The more you can save for retirement, the better your chances of retiring comfortably. One of the best ways to save for retirement is to max out your contributions to an employer-sponsored retirement plan, such as a 401(k) plan, up to the legal limit.
Why is an employer-sponsored retirement plan such a good retirement savings vehicle? One reason is that your pre-tax contributions to your employer’s plan lower your taxable income for the year. This means you save money in taxes when you contribute to the plan. For example, if you earn $100,000 per year and you contribute $10,000 to a 401(k) plan, you’ll pay income taxes on $90,000 instead of $100,000.
Another reason is the power of tax-deferred growth. With an employer-sponsored retirement plan, any investment earnings have the potential to compound year after year and aren’t taxable as long as they remain in the plan. Over the long term, deferring taxes could leave you with a much larger balance than that of someone who invests the same amount in taxable investments at the same rate of return.
Also, keep in mind that when you do take withdrawals from an employer-sponsored retirement plan, federal and state income taxes will be due at current rates on your pre-tax contributions, any employer contributions, and any investment earnings (special rules apply to Roth accounts). Also, early withdrawals will generally be subject to a 10% penalty tax.
Creating an Investing Road Map for Retirement.
SET RETIREMENT GOALS
Setting goals for retirement is an important part of retirement investing. For example, do you want to retire early? Would you like to travel during retirement? Do you plan on working post-retirement? Having goals can help you and your financial professional develop an appropriate investment plan for your retirement.
THINK ABOUT YOUR TIME HORIZON
One of the first questions you should ask yourself before you invest for retirement is “When will I need the money?” Will it be in three years or 30? Your time horizon for when you would like to retire will have a significant impact on your retirement investment strategy.
The general rule is: the longer your time horizon, the more risky (and potentially more lucrative) investments you may be able to make. Many financial professionals believe that with a longer time horizon, you can ride out fluctuations in your investments for the potential of greater long-term returns. On the other hand, if your time horizon is very short, you may want to concentrate your investments in less risky vehicles because you may not have enough time to recoup losses should they occur.
UNDERSTAND YOUR RISK TOLERANCE
Another important question is “What is my investment risk tolerance?” How do you feel about the potential of losing your hard-earned money? Many investors would forgo the possibility of a large gain if they knew there was also the possibility of a large loss. Other investors are more willing to take on greater risk to try to achieve a higher return. You can’t completely avoid risk when it comes to investing, but it’s possible to manage it.
Almost universally, when financial professionals or the media talk about investment risk, their focus is on price volatility. Advisors label as aggressive or risky an investment whose price has been prone to dramatic ups and downs in the past, or that involves substantial uncertainty and unpredictability. Assets whose prices historically have experienced a narrower range of peaks and valleys are considered more conservative.
In general, the risk-reward relationship makes sense to most people. After all, no sensible person would make a higher-risk investment without the prospect of a higher reward for taking that risk. That is the tradeoff. As an investor, your goal is to maximize returns without taking on more risk than is necessary or comfortable for you. If you find that you can’t sleep at night because you’re worrying about your investments, you’ve probably assumed too much risk. On the other hand, returns that are too low may leave you unable to reach your retirement goals.
The concept of risk tolerance refers not only to your willingness to assume risk but also to your financial ability to endure the consequences of loss. That has to do with your stage in life, how soon you’ll need the money for retirement, and your retirement goals.
REMEMBER YOUR LIQUIDITY NEEDS
Liquidity refers to how quickly you can convert investments into cash. For example, as an investment, your home would be considered relatively illiquid, since it can take a very long time to sell. Publicly traded stock, on the other hand, tends to be fairly liquid.
Your need for liquidity will affect the types of investments you might choose to meet your retirement goals. For example, if you have an emergency fund, you’re in good health, and your job is secure, you may be willing to hold some less liquid investments that may have higher potential for gain. However, you probably don’t want to invest money you’ll need in the next couple of years in less liquid assets. Also, having some relatively liquid investments may help protect you from having to sell others when their prices are down.
Don’t Forget About Asset Allocation.
The combination of investments you choose for your retirement portfolio can be as important as your specific investments. The mix of various asset classes, such as stocks, bonds, and cash alternatives, account for most of the ups and downs of a portfolio’s returns.
Deciding how much of each you should include is one of your most important tasks as an investor. The balance between potential for growth, income, and stability is called your asset allocation. It doesn’t guarantee a profit or insure against a loss, but it does help you manage the level and type of risks you face.
BALANCING RISK & RETURN
Ideally, you should strive for an overall combination of investments that minimizes the risk you take in trying to achieve a targeted rate of return. This often means balancing more conservative investments against others that are designed to provide a higher return but that also involve more risk. For example, let’s say you want to get a 7.5% return on your money. You learn that in the past, stock market returns have averaged about 10% annually, and bonds roughly 5%. One way to try to achieve your 7.5% return would be by choosing a 50-50 mix of stocks and bonds. It might not work out that way, of course. This is only a hypothetical illustration, not a real portfolio, and there’s no guarantee that either stocks or bonds will perform as they have in the past. But asset allocation gives you a place to start.
Many publications feature model investment portfolios that recommend generic asset allocations based on an investor’s age. These can help jump-start your thinking about how to divide up your investments. However, because they’re based on averages and hypothetical situations, they shouldn’t be seen as definitive. Your asset allocation is — or should be — as unique as you are. Even if two people are the same age and have similar incomes, they may have very different needs and goals for retirement. You should make sure your asset allocation is tailored to your individual circumstances.
THE MANY WAYS TO DIVERSIFY
When financial professionals refer to asset allocation, they’re usually talking about overall classes: stocks, bonds, and cash or cash alternatives. However, there are others that also can be used to complement the major asset classes once you’ve got those basics covered.
Even within an asset class, consider how your assets are allocated. For example, if you’re investing in stocks, you could allocate a certain amount to large-cap stocks and a different percentage to stocks of smaller companies. Or you might allocate based on geography, putting some money in U.S. stocks and some in foreign companies. Bond investments might be allocated by various maturities, with some money in bonds that mature quickly and some in longer-term bonds.
MONITORING YOUR RETIREMENT PORTFOLIO
Even if you’ve chosen an asset allocation, market forces may quickly begin to tweak it. For example, if stock prices go up, you may eventually find yourself with a greater percentage of stocks in your retirement portfolio than you want. If they go down, you might worry that you won’t be able to reach your retirement goals. The same is true for bonds and other investments.
Do you have a strategy for dealing with those changes? Of course you’ll probably want to take a look at your individual investments, but you’ll also want to think about your asset allocation. Just like your initial investing strategy, your game plan for fine-tuning your retirement portfolio periodically should reflect your investing personality.
Even if you’re happy with your asset allocation, remember that your circumstances will change over time. Those changes may affect how well your investments match your retirement goals. At a minimum, you should periodically review the reasons for your initial choices to make sure they’re still valid. Also, some investments, such as mutual funds, may actually change over time; make sure they’re still a good fit.