By Michael Guillemette
Saving and investing for retirement can seem very complicated, but following a few simple rules can make a significant difference in the long run:
1. Save early and often
The earlier you start saving for retirement the less you will need to save. For example, if a 25 year-old wants to have 2 million dollars in 40 years he or she would need to save $1,004 per month for 40 years, assuming a 6% annual rate of return. If that same person waited until they were 35 to begin putting money away they would need to save $1,991 per month for 30 years, or almost double the amount!
It is advisable to setup automatic contributions from a checking or savings account into a retirement plan like an individual retirement arrangement (IRA). This is because when people have to think about whether to save they often delay the decision. Setting up automatic contributions is a great way to put retirement savings on “autopilot” and avoid the temptation to spend the money.
2. Diversify in stocks and bonds
When it comes to investing, diversification is vital to earning the best possible risk-adjusted return. The concept is simple. You want to invest in products that tend to do well during good economic times (like stocks) and also bad economic times (like bonds). This way you do not put all of your eggs in one basket and the result is a steadier return over time. It is important to invest in low cost mutual funds or exchange traded funds (ETF) that hold a large number of stocks or bonds (or both).
When people are young and have a greater level of human capital they can afford to invest a higher percentage of their retirement savings in stock funds. This is because they have a larger amount of future earnings that can offset the risk associated with stocks. However, as people age and their human capital declines it is more difficult to offset the risk associated with stocks. Therefore, a higher percentage of retirement assets should be allocated to bonds as people age. A target-date (or age-based) fund is a mutual fund or ETF that holds a mix of stocks and bonds. Target-date funds automatically increase the percentage allocated to bonds over time to account for the decline in human capital and are good “autopilot” investment products.
3. Understand your risk tolerance
It is important to consider your risk tolerance, or willingness to take risk, prior to investing in stocks and bonds. The key thing to remember is that if an investment keeps you up at night, it is too risky. The amount of money someone has is irrelevant in relation to how much risk they are willing to take. Many retirees who grew up during the Great Depression have saved significant sums of money but are not willing to lose any of it, and therefore do not invest in stocks.
4. Don’t time the market!
The easiest way to lose money investing in stocks and bonds is to try and time the stock market, or jump in and out based on the current economic environment. Research has shown that investors lose significant returns by trying to time the stock market. Since retirement is a long-term goal, the daily, monthly and even annual performance of your stock and bond funds does not really matter. This is because over the long-run, a mix of stocks and bonds provides steady growth. Warren Buffett provides similar investment advice in this video: https://www.youtube.com/watch?v=idr6c8NHuWs
Michael Guillemette, Ph.D.
Department of Personal Financial Planning
University of Missouri