Jane Young, CFP, EA
Deciding upon an asset allocation is one of the first and most significant decisions to be made when you start investing. Your asset allocation is the percentage of different types of investments such as cash, bonds, stock or real estate that make up your investment portfolio. Probably one of the most important allocations is that between investments in the stock market and investments in interest earning vehicles such as bank accounts, CDs and bonds. An ideal asset allocation provides a balance between risk and return that helps you meet your goals but doesn’t keep you awake at night.
There is a trade-off between risk and return. Generally, if you want a higher return you need to assume a higher level of risk. Investment risk comes in many different forms with the most common being stock market risk. Historically, over long periods of time, the stock market has out-performed most other investments. However, in the short term it can be extremely volatile, including years with negative returns. In the extreme case you could lose your entire investment in an individual stock. To reduce risk in the stock portion of your portfolio, consider buying diversified stock mutual funds. You will still experience swings in the market but fluctuations in any one stock will have less impact.
On the other hand, interest earning investments such as bank accounts, CDs, bonds and bond funds are generally less risky and are not subject to stock market fluctuations. Unfortunately, in exchange for this lower level of risk you may earn a much lower rate of return.
Additionally, bonds and bond funds are subject to interest rate risk and default risk. If you purchase a bond or bond fund and interest rates increase, the value of your investment will decrease. To make matters worse, when interest rates rise bond funds commonly experience a flood of redemptions forcing them to sell bonds within the fund at a loss. Even if you hold on to your shares you can experience a drop in value. However, if you purchase an individual bond and hold it till maturity you will receive the full value upon redemption. Use caution when buying low quality bonds or bond funds; you may get a higher return but you are subject to a much greater risk of default.
Many investors don’t consider inflation risk. This results from taking too little risk with a conservative portfolio containing little or no stock. Over time inflation has averaged about 3% annually, if you are only earning 2% on your portfolio your real return after inflation will be negative. This is compounded if inflation rates rise significantly. Consider increasing your allocation in the stock market to hedge against inflation risk.
In the current environment of low interest rates and high volatility it’s crucial to build a portfolio that balances risk and return to support your financial goals and provide you with peace of mind.
While driving home recently I was disconcerted by another commercial spouting false information and preying on investor fear. This commercial was exaggerating the danger and volatility of the stock market by implying most investors lost millions in the 2008 and 2009 market crash. In reality if you were invested in the stock market from 2006 to 2016 you would have seen a 65% increase in your stock portfolio. If you didn’t sell when the market dropped, you would have experienced a reasonable return rather than a loss on your investment. Commercials like this stir up fear and anxiety then promise the perfect solution to market volatility – the magic to provide great returns without taking risk.
There is no miracle product that is going to provide you with high returns without risk. If it sounds too good to be true, it is! A basic concept of investing is the trade-off between risk and return. If you want more return you will have to absorb greater risk. If you want a risk free investment you will be limited to CD’s and US government bonds that pay very low interest rates. If you want to earn higher returns you will need to take on some risk and invest part of your portfolio in the stock market.
The mystery product in commercials and ads that promise high returns with no risk is often a variable annuity. While on occasion the use of an annuity may be appropriate for a portion of your portfolio, most variable annuities come with significant disadvantages. A variable annuity is an insurance vehicle that invests your money into separate accounts similar to mutual funds. Annuities are complex insurance contracts that are commonly sold on commission, with built-in fees and significant restrictions on when and how you can withdraw your money. Earnings on money invested in a variable annuity grow tax deferred but are taxed at regular income tax rates when withdrawn.
Insurance salespeople influence you to buy annuities by promising protection from market volatility. Basically, in addition to paying the typical fees and commissions, you can purchase an insurance rider to guard against a drop in the market. However, this insurance usually only applies to a death benefit or the base amount used to calculate an annual income stream. If you think a variable annuity is appropriate for your situation make sure you fully understand the product’s benefits and restrictions before investing. Also consider an annuity with no or a low commission and without restrictions on when and how you can access your money.
A better option for managing market volatility may be to invest in a diversified portfolio that supports your time horizon. Avoid the need or temptation to withdraw money from the stock market when it’s down. Invest money needed in the short term in safe investments and limit your stock market investments to long term money.
Jane Young, CFP, EA
In our 50’s we still have time to plan and save for retirement and it’s close enough that we can envision ourselves in retirement. Below are some things to address as you plan for retirement.
- Set some goals and make plans, what does your retirement look like? Consider your path to retirement and your timeframe – you can gradually transition by working fewer hours in your current job, work part time in a new career field or completely stop working. Think about how you will spend your time in retirement. Work usually provides us with mental stimulation, a sense of purpose and accomplishment, social interaction and a sense of identity. How will you meet these needs in retirement?
- Evaluate your current situation. Take a thorough look at current expenses and assets. Analyze your spending habits and compare this to your earnings. Look for opportunities to save money to invest and prepare for retirement.
- Ramp up savings and maximize your retirement contributions – try to save at least 10% to 15% of your annual income. Increase contributions to your 401k and IRA to take advantage of catch-up provisions. These are your highest earning years where you can really benefit from investing in tax deferred retirement plans.
- Invest in a diversified portfolio that will grow and keep up with inflation. Your retirement savings is long term money that will need to last another 30 – 40 years. A reasonable portion of this money should be invested in stock mutual funds to provide you the growth needed to carry you through retirement.
- Take steps to reduce your retirement expenses – pay off high interest debt, credit cards and vehicle loans. Make extra payments on your mortgage to pay it off around the time you retire.
- Think about where and how you want to live. Do you want to move to a lower cost area or downsize to a smaller home? Put plans in place to meet your goals. Complete major remodeling, repairs and upgrades on appliances before you go into retirement.
- Develop a retirement budget. Consider the impact of inflation and taxes on your monthly outflow. Many retirees are more active and spend more early in retirement. Include expenses for health care and long term care in your budget.
- Evaluate your Social Security options. Delay taking Social Security benefits as long as possible, up to age 70.
- Calculate how much you need to pull from your retirement savings by subtracting your monthly expenses from your Social Security and pension benefits. As a rule of thumb, avoid spending more than about 4% of your retirement savings per year. This will vary with the amount of risk you are comfortable taking in your portfolio. To get a more precise projection on when you can retire, how much you can spend and how much you should save, periodically work with a financial planner on some formal retirement planning.
Jane Young, CFP, EA
We recently built a new home and have been feverishly working on landscaping and planting new flower beds. While going through the process of planting and nurturing my flower gardens I realized there are many similarities between gardening and investing. I planted a lot of perennials to create a garden that will last for many years. However, I’m anxious for the perennials to grow into the large, colorful flowers I have envisioned. I realize it takes time and patience to develop a gorgeous garden. To satiate my immediate need for some color I interspersed some annuals with the perennials. The annuals will meet my short term needs but aren’t a good long term investment. They will provide beautiful color this year but will die and won’t return next spring
To build a successful garden you have to plan ahead, prepare the earth and plant seeds long before reaping the benefits. Investing is similar to gardening in that you need to think ahead to create a plan that will meet your long term objectives. You have to start by planting the seeds and continue feeding and nurturing your investment plan. After your initial investment is made, continue making contributions and annually re-balance your portfolio to be sure you stay on track. Periodically some weeding is required to remove poor performing or inappropriate investments from your portfolio. You may also need to add some nutrients by adding better performing mutual funds or by expanding on the categories of funds in which you are invested.
It’s essential to meet short term needs. This year I had a short term need for some annuals to add color to the garden. In your portfolio, you need to include short term money for emergencies and living expenses. If short term needs are addressed you can invest your long term money more effectively with greater confidence.
Additionally, in both gardening and investing it’s important to stay diversified. My garden has a variety of flowers that bloom at different times of the year or react differently to varying weather conditions. Your portfolio should also be diversified with a variety of different investments that help you buffer against a variety of market conditions and changes in your personal life.
Just like perennials in the garden, investments in your portfolio need time to grow and absorb fluctuations in the market. If you become impatient and give up before they have time to fully bloom you won’t meet your end goal. Just as vibrant short term annuals can provide a lot of immediate satisfaction they don’t result in a garden that is sustainable over many years.
Investing, as in gardening, is a slow and steady process. Get started, set a plan, keep a long term perspective and stick to your plan. Patience and perseverance will help you build a gorgeous garden and a more secure financial future.