retirement post has been one of the most viewed. In order to make some of those dreams more realistically achievable, I thought I'd write another post looking at my idea of an ideal retirement strategy. I will talk about the basic strategies that go into investment planning and how that will apply to planning for retirement.
The two main considerations that you should take into account when determining an investment style are your risk tolerance and time horizon. Risk tolerance can be understood as how much loss are you will to take for a chance of higher gains. Those with low risk tolerance panic when there are large (downward) moves in the value of their portfolio and would prefer to avoid them at all costs (even the cost of higher gains in the long-run). People with a high risk tolerance are better able to stomach wide swings in the value of their portfolio and are usually rewarded in the long-run with higher returns. In order to invest your savings to match your risk tolerance, you should take a closer look at my risk management post. This often leads to people with lower risk tolerances to put more money in fixed-income securities like bonds or other safer assets while those with higher risk tolerances put more money into stocks. No matter what your risk tolerance is, however, people still sometimes inefficiently allocate their money when investing. All portfolios can benefit from diversification which is essentially a way to maximize your return for a given level of risk. And because of the benefits of diversification, ETFs have become quite popular for retirement money.
The reason why risk tolerance is important is because most investors who hold onto riskier assets than they can stomach usually do poorly with them. If you are risk-averse and hold onto a stock which loses 20%, you may make a poor decision to sell or hold based on your emotions. For example, you may panic and sell to prevent further losses, only to have the stock jump back up and skyrocket to future gains. Or you may decide to hold onto the stock and just wait it out, and suffer as it continues to fall. Emotions can prevent us from evaluating investments objectively, so you should most closely match your investment style with your risk tolerance.
The other consideration you should take is your time horizon. The idea behind your time horizon has some overlap with risk tolerance. Basically, the longer away from your planned date of retirement, the riskier your portfolio should be in order to get larger returns. For college students like myself, it is much better to have a larger percentage of money in stocks because over years and decades, stocks yield around 8-10%. On any given year, however, the stock could skyrocket up 30% or crash down 30%. A government bond, on the other hand, is practically sure to pay out whatever interest rate listed when you purchase it. Thus, when your retirement is, say, 40 years away, you can probably take on those wide 20-30% swings in the stock market to get a larger average return. You probably won't need the money in your retirement funds since you earn money by working so the losses can be offset by future gains in the markets. If you are a few years away from retirement, however, a 20% loss in your portfolio may not regain its value until after you actually need the money. So, you should invest more in safer securities like bonds, to prevent wide fluctuations in the value of your portfolio as you approach retirement age.
Another way of looking at how to invest your money is by classifying yourself as an asset. While we are young and working, our income can be thought of like payouts from a bond. Our jobs should be fairly stable and pay out a specified amount each year. Thus, during our early years, much of our investment is tied up in a bond-like asset which suggests that we would do better by investing most of our extra savings in riskier assets like stocks. When we retire and stop working, we lose that bond-like investment in our job and need to move our money into bonds and other fixed-income securities.
After taking into consideration your risk tolerance and time horizon, you should allocate your investments and then try to maximize your after-tax return by contributing to IRAs or a 401k. By switching the type of account your investments are in, you can save quite a hefty sum in taxes by the time you need the money.
These investing strategies don't have to be for retirement funds. Your normal investments should take into consideration your risk tolerance and time horizon (if you plan to use the money to buy a house for example, how far into the future are you planning to take the money out of the investment?). For those of you who aren't sure how to go about how to actually invest your money, take a look at my posts on buying stocks and reviews of certain brokers like Optionshouse and Tradeking.