Jane M. Young
As we approach retirement, there is a common misconception that we need to abruptly transition our portfolios completely out of the stock market to be fully invested in fixed income investments. One reason to avoid a sudden shift to fixed income is that retirement is fluid; it is not a permanent decision. Most people will and should gradually transition into retirement. Traditional retirement is becoming less common because life expectancies are increasing and fewer people are receiving pensions. Most people will go in and out of retirement several times. After many years we may leave a traditional career field for some well-deserved rest and relaxation. However, after a few years of leisure we may miss the sense of purpose, accomplishment, and identity gained from working. As a result, we may return to work in a new career field, do some consulting in an area where we had past experience or work part-time in a coffee shop.
Another problem with a drastic shift to fixed income is that we don’t need our entire retirement nest egg on the day we reach retirement. The typical retirement age is around 65, based on current Social Security data, the average retiree will live for another twenty years. A small portion of our portfolio may be needed upon reaching retirement but a large percentage won’t be needed for many years. It is important to keep long term money in a diversified portfolio, including stock mutual funds, to provide growth and inflation protection. A reasonable rate of growth in our portfolio is usually needed to meet our goals. Inflation can take a huge bite out of the purchasing power of our portfolios over twenty years or more. Historically, fixed income investments have just barely kept up with inflation while stock market investments have provided a nice hedge against inflation.
We need to think in terms of segregating our portfolios into imaginary buckets based on the timeframes in which money will be needed. Money that is needed in the next few years should be safe and readily available. Money that isn’t needed for many years can stay in a diversified portfolio based on personal risk tolerance. Portfolios should be rebalanced on an annual basis to be sure there is easy access to money needed in the short term.
A final myth with regard to investing in retirement is that money needed to cover your retirement expenses must come from interest earning investments. Sure, money needed in the short term needs to be kept in safe, fixed income investments to avoid selling stock when the market is down. However, this doesn’t mean that we have to cover all of our retirement income needs with interest earning investments. There may be several good reasons to cover retirement expenses by selling stock. When the stock market is up it may be wise to harvest some gains or do some rebalancing. At other times there may be tax benefits to selling stock.
Jane M. Young
Generally the typical investor is better off investing in stock mutual funds than in individual stocks. A mutual fund is an investment vehicle where money from a large number of investors is pooled together and invested by a professional manager or management team. Mutual fund managers invest this pool of money in accordance with a predefined set of goals and guidelines.
One of the primary benefits of investing in stock mutual funds is the ability to diversify across a large number of different stocks. With mutual funds, you don’t need a fortune to invest in a broad spectrum of stocks issued by large and small companies from a variety of different industries and geographies. Diversification with mutual funds reduces risk by providing a buffer against extreme swings in the prices of individual stocks. You are less likely to lose a lot of money if an individual stock plummets. Unfortunately, you are also less likely to experience a huge gain if an individual stock skyrockets.
Another benefit of stock mutual funds over individual stocks is that less time and knowledge is required to create and monitor a portfolio. Most individual investors do not have the time, expertise, or resources to select and monitor individual stocks. Mutual funds hire hundreds of analysts to research and monitor companies, industries and market trends. It is very difficult for an individual to achieve this level of knowledge and understanding across a broad spectrum of companies. Mutual fund managers have the resources to easily move in and out of companies and industries as investment factors change.
Most individual investors appreciate the convenience of selecting and monitoring a diversified portfolio of mutual funds over the arduous task of selecting a large number of individual stocks. Stock mutual funds are a good option for your serious money. However, if you really want to play the market and invest in individual stocks, use money that you can afford to lose.
For diehard stock investors, there are some advantages to investing in individual stocks. Many stock mutual funds charge an annual management fee of between .50% and 1% (.25% for index funds). With individual stocks, there is a cost to buy and sell the stock but there is no annual management fee associated with holding stock.
Another advantage of individual stocks is greater control over when capital gains are recognized within a non- retirement account. When you own an individual stock, capital gains are not recognized until the stock is sold. In a high income year, you can delay selling your stock, and recognizing the gain, to a year when it would be more tax efficient. On the other hand, when you invest in a stock mutual fund you have no control over capital gains on stock sold within the fund. Capital gains must be paid on sales within the mutual fund, before you actually sell the fund. Mutual funds are not taxable entities, therefore all gains flow through to the end investor.
Jane M. Young
Let’s compare some differences between stocks and bonds. When you buy a bond you are essentially lending money to a corporation or government entity for a set period of time in exchange for a specified rate of interest. When you invest in the stock market you assume an ownership position in the company whose stock you are purchasing. As a result, the value of your investment will fluctuate based on the profit or loss of the underlying company. With the purchase of a bond the value of your investment hould not fluctuate based on the financial performance of the issuer, assuming it remains solvent. You will continue to receive interest payments according to the original terms of the agreement until the bond matures. Upon maturity the amount of your original investment (principal) will be returned to you along with any interest that is due. As a general rule, stocks are inherently more risky than bonds, therefore investors expect to receive a higher return.
Bonds may appear to be safe but they are not without risk. Currently, there is some risk associated with low interest rates that may not keep up with inflation. This is especially true with many government bonds. Two additional risks typically associated with bonds include default risk and interest rate risk.
Default risk is the risk that the issuer goes bankrupt and is unable to return your principal. Most bond issuers are assigned a rating to help investors assess the potential default risk of a bond. Generally, investors are compensated with higher interest rates when taking a risk on lower rated bonds and receive lower interest rates on higher rated bonds.
Interest rate risk is based on the inverse relationship between interest rates and the value of a bond. When interest rates increase the value of a bond will decrease and when interest rates decrease the value of a bond will increase. If you hold an individual bond until maturity your entire principal should be returned to you. You have the control to keep the bond until maturity and avoid a loss. However, if you need to sell before maturity you may lose some principal. The loss of principal is greater for longer term bonds. This needs to be weighed against the benefit of a higher interest rate paid on longer term bonds.
Bond mutual funds can provide diversification and reduced default risk because your money is pooled with hundreds of other investors and invested in bonds from a large number of different entities. If one or two entities within the mutual fund go bankrupt there will be minimal impact on each individual investor. However, with mutual funds you have less control over interest rate risk. When interest rates increase, bond fund managers often experience a high rate of withdrawals forcing them to sell bonds at an inopportune time. This usually results in a loss of principal, the severity of which is greater for longer term bond funds.