Fermenting your future…5 Keys to Investing for your Retirement
Fermenting your future…5 Keys to Investing for your Retirement
Making decisions about your retirement account may seem intimidating, especially if investing is a new concept to you. However, following these basic rules can guide you to making smart choices regardless of if you’re an investing veteran or rookie:
- Don’t let inflation win
You can see how inflation affects gas prices, electric bills, and the cost of food (and beer!); over time, your money buys less and less. But what inflation does to your investments isn’t always as clear. Hypothetically: let’s say your money is earning 4% and inflation is running between 3% and 4% (the historical average). That means your investments could be only earning 1% at best. And that’s not counting any other costs, even in a qualified account like a 401(k) where taxes are deferred, you’ll eventually owe taxes on that money. Unless your retirement accounts are keeping pace with inflation, you could be actually losing money (in the form of buying power), without even realizing it.
So what does this mean for your retirement strategy? First, you might need to contribute more to your retirement plan than you think. What seems like a healthy sum now will seem smaller and smaller over time. At a 3% annual inflation rate, something that costs $100 today would cost $181 in 20 years. You’d need a bigger retirement nest egg than you anticipated. Another factor to consider is that people are living longer than they used to, so we could spend more time in retirement than our parents and grandparents. We usually suggest increasing your 401(k) contribution each year, as a birthday gift to your future self. Your future self will thank you!
Secondly, it may be a good idea to invest at least a portion of your retirement plan in investments that can help keep inflation from silently eating away at the buying power of your savings. Cash alternatives such as money market accounts can be generally low risk, but they are likely to not keep pace with inflation over time. Even if you consider yourself a conservative investor, stocks have historically provided higher long-term total returns than cash alternatives or bonds, even though they also involve greater risk of volatility and potential loss.
Note: Past performance is no guarantee of future results.
- Invest based on your time horizon
Like waiting for beer to ferment, your time horizon is investment-speak for the amount of time you have left until you plan to use the money you’re investing. Why is this important? Because it can affect how well your portfolio can handle the ups and downs of the financial markets. Someone who was planning to retire in 2008 and was heavily invested in the stock market faced different challenges from the financial crisis than someone who was investing for a retirement that was many years away, because the person nearing retirement had fewer years to recover from the downturn.
If you have a long time horizon, you may be able to invest a greater percentage of your money in something that could experience more dramatic price changes but also might have a greater potential for long-term growth. Past performance doesn’t guarantee future results, but long-term the stock market has historically gone up despite its frequent and sometimes massive ups and downs.
We often say that our industry is the one industry where people freak out when there is a “sale.” The longer you stay with a diversified portfolio of investments, the more likely you will be able to ride out market downturns and improve your opportunities for gain.
- Take a look at your risk tolerance
Another key factor is your risk tolerance, which means how well you can handle a possible investment loss. There are two aspects to risk tolerance. First is your financial ability to survive a loss. If you need the money soon, for example you plan on using your retirement savings in the next year or so, those needs reduce your ability to withstand even a small loss. However if you’re investing for the long haul, don’t expect to need the money immediately, or have other assets to rely on in an emergency, your risk tolerance might be higher.
The second aspect is your emotional ability to withstand the possibility of loss. If you’re invested in a way that concerns you, you may need to think about reducing the amount of risk in your portfolio. Many people think they’re comfortable with risk, only to find out when the market takes a turn for the worse that they’re actually a lot less risk-tolerant than they thought. Often that means they wind up selling in a panic when prices are the lowest. We often say the markets will do what they do, and they don’t care about how you feel.
Keep in mind that there are ways to manage risk. For example, understanding the potential risks and rewards of each of your investments and its role in your portfolio may help you gauge your emotional risk over time. By investing regularly, you help reduce the chance of investing a large sum just before the market takes a downturn.
- Blend retirement with your other financial goals
Think about getting an emergency fund in place; it can help you avoid needing to tap into your retirement savings before you had planned to. Nobody wants to tap into their retirement before they need to, just like nobody wants to tap into the bourbon barrel aged stout before it has been in there long enough! Generally, if you withdraw money from a traditional retirement plan before you turn 59½, you’ll owe not only the amount of federal and state income tax on that money, but also an additional 10% federal penalty (and sometimes a state penalty as well). There are exceptions to the penalty for premature distributions from a 401(k) (for example, having a qualifying disability or withdrawing money after leaving your employer after you turn 55). However, having an additional separate emergency fund can help you avoid an early distribution and allow your retirement money to stay invested.
If you have outstanding debt, you’ll need to weigh the benefits of saving for retirement versus paying off that debt as soon as possible. If the interest rate you’re paying is high, you might benefit from paying off at least part of your debt first. If you’re contemplating borrowing from or making a withdrawal from your workplace savings account, make sure you investigate using other financing options first, such as loans from banks, credit unions, friends, or family. If your employer matches your contributions, don’t forget to factor into your calculations the loss of that matching money (we call it free money from your employer).
- Don’t “brew” just one style
Much like in the beer world where the key to success is “sanitation, sanitation, sanitation,” in the financial planning world, the key to success can be “diversify, diversify, diversify.” Diversifying your retirement savings across many different types of investments can help you manage the ups and downs in the markets. For example, when most people think of risk or volatility, they think of market risk which is the possibility that an investment will lose value because of a general decline in the financial markets. However, there are many other types of risk. For example, bonds face default or credit risk (the risk that a bond issuer won’t be able to pay the interest owed on its bonds, or repay the principal borrowed). Bonds also face interest rate risk, because bond prices generally fall when interest rates rise. International investors may face currency risk if exchange rates between U.S. and foreign currencies affect the value of a foreign investment. Political risk is created by legislative actions (or lack of them).
These are just a few examples of the various types of risk. However, one investment may respond to the same set of circumstances very differently than the other and have different risks. That’s why it’s a good idea to put your eggs in different baskets. In a craft brewery tasting room, there is generally a wide variety of beer styles available for all types of beer drinkers. Some consumers have different styles they enjoy, so it’s usually a good idea to have a variety of styles on tap to choose from. Spreading your portfolio over several different types of investments can help you manage the types of risk you face.
Participating in your retirement plan is probably more important than any individual investing decision you’ll make. Keep it simple, stick with it, and time can be a strong ally.
*Any opinions are those of Eddie Martin and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Investments mentioned may not be suitable for all investors. Investing involves risk and investors may incur a profit or loss. Diversification does not guarantee a profit nor protect against a loss.
