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Your Retirement Questions Answered, Part I - Live Like a Mensch
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Live Like a Mensch

Your Retirement Questions Answered, Part I

Photo of the world's coolest retired couple courtesy of Alex Proimos

 

I mentioned several weeks ago that I will be spending my May semi-hiatus from blogging doing research and writing a book about retirement. I also invited you all to pepper me with retirement questions that you've always been afraid to ask.

I have to tell you, reading your questions produced small animal noises of terror from this researcher/writer. I went into this project with a sense of unwarranted confidence. I know money stuff, I thought to myself as I signed the contract to write AN ENTIRE BOOK. This will be a piece of cake.

Then I read through your questions, and I realized there's a reason why people make a living advising people on how to retire. This stuff is complimicated!

So after a few days spent hiding under a desk emitting high-pitched anxiety noises, I started doing my research. I'm still not feeling like an expert, but I feel much more confident about my ability to know where to find answers. (I'm still waiting for the tax code to make sense to me, particularly vis-a-vis retirement, but I suspect I'll be waiting a long time for that one.)

In any case, I wanted to get started answering your retirement questions today, and I thought I'd start off with the excellent question from maggie.glos:

"As a younger person, I am always confused with whether it is better to put my retirement money into one of the funds based on my age and how many years to retirement or if I should be trying to put it into certain stocks. Which is wiser?"

Part of the reason why this is a tough question to answer is because the answer depends somewhat on you and your personal investing style and risk tolerance. Specifically, if you want to personally play the stock market and you have a high risk tolerance, then you'll be unhappy putting money into a mutual fund based on how far you are from retirement. But if you're somewhat risk averse and a set-it-and-forget-it type of investor (which definitely describes me), then mutual funds will be the way to go.

However, since there are very few people who fit that first descriptor, I'll answer Maggie's question as if she's more like the second type of investor.

One of the reasons why it may seem wiser to pick certain stocks is because of how they have historically performed. But if you visit any financial adviser or read any prospectus, you'll see the words "Past performance is no guarantee of future returns" written somewhere, spoken aloud, embroidered on a pillow, or tattooed on a forehead. Any stock that has gone gangbusters can't promise that it will continue to do so--just ask anyone who invested in dotcoms in 2000 or real estate in 2007.

So, historical performance is not a way to pick a stock. That means you're left with other metrics, like the soundness of the company, the performance of the market as a whole, or your gut, which are equally imperfect methods for choosing a particular stock.

That's why most investors mitigate their risk by buying into mutual funds. These funds diversify the investment by buying into many different securities (securities is a term that includes stocks, bonds, and derivatives)--and mutual funds include professional management of the investments.

Basically, Maggie, it's going to be wiser for 99% of workers to choose a fund rather than pick specific stocks.

However, that doesn't completely answer your question. I was under the impresson that you also weren't sure how to go about choosing funds. This is a common problem, and in fact, it is the stumbling block for many many people and can often be the reason why workers don't buy into their company 401(k). They just can't bear the thought of having to read through all the information and make choices.

Thankfully, it's not as difficult as you might think.

Start by determining your risk tolerance. Bankrate has a "fun" version of the usual risk tolerance quiz that can help you determine how secure you can feel with your money in volatile investments.

Once you know how conservative or aggressive you are, you're ready to start determining which fund is best for you. Look at the investment objectives of your available options. These objectives will be stated clearly in the prospectus for each of your options.

As a young person still decades away from retirement, the best objectives will be growth or capital appreciation (either of these terms might be used). If you are particularly conservative, you might temper those growth assets with more balanced assets. For example, you might choose to put 50% in an S&P 500 Index Fund and 10% in an international stock fund, both of which would provide you with a growth objective, and the remaining 40% in a bond fund that would provide you with more stability. A more aggressive peer might change those rations to 60% S&P, 20% international stock, and 20% bonds. But in either case, a young investor needs to make capital appreciation a priority.

As you get closer to retirement--within ten years, let's say--you'll want to start transitioning from an accumulation mentality to rebalancing. This will be when you start scaling back on the aggressive allocations (which are generally stocks) and amping up your balanced allocations (funds that are a combination of stocks and bonds).

When you reach retirement, you will then want to move into allocations that will produce income in your retirement--things like bonds that offer income objectives. 

The third investment objective you'll see is safety/stability of principle. You'll see that on cash equivalents like CDs, T-Bills and money market funds. These will not keep pace with inflation, which means that even though you theoretically can't lose principle with these, you are still losing money in the long run because your principle will be able to buy less and less over the years. Go for stability with money you need to keep liquid, but this is not a real investment strategy.

So, to make a long story short, for most people it is wiser to choose funds based on your age/years to retirement.

 

Phew. Is anyone else sweating? I feel like I just ran a 5k.

Maggie, I hope this answered your question. For everyone else, please let me know if there is anything you'd like me clarify or if you have any other retirement questions you would like answered. The comment line is open!

Comments

 

frugal_fun said:

"(I'm still waiting for the tax code to make sense to me, particularly vis-a-vis retirement, but I suspect I'll be waiting a long time for that one.)"

LOL - There are people who do nothing but specialize in the retirement portion of the tax code. I feel sketchy about it and I do taxes. :)

"That's why most investors mitigate their risk by buying into mutual funds. These funds diversify the investment by buying into many different securities (securities is a term that includes stocks, bonds, and derivatives)--and mutual funds include professional management of the investments."

I would only add that if you're going to do mutual funds, skip the professional management (if you can) and go straight to index funds. In all seriousness, most professional managers have extremely poor track records against the indexes. It's possible to blow hundreds/thousands in management fees just to fair worse (sometimes far worse) than the market. The best investment managers work in hedge funds and the 'average' investor has no access to those. Simply choosing an index fund or ETF based on an index eliminates the waste of paying a person to what a computer does better. (This sooo a Dollar Stretcher tip :) ).

"You'll see that on cash equivalents like CDs, T-Bills and money market funds. These will not keep pace with inflation, which means that even though you theoretically can't lose principle with these, you are still losing money in the long run because your principle will be able to buy less and less over the years. Go for stability with money you need to keep liquid, but this is not a real investment strategy. "

This assumes that market is up when you need the money at retirement. It's possible to lose everything in stocks, rather than just lose ground to inflation. The total loss possibility is mitigated substantially by choosing an index fund.  However, if you see several years of haircuts in a row (secular bear market) it will take a great deal of growth at the end just to return principle.

The problem is that in order to really grow wealthy, you can't use other people's businesses (ie stocks). Stocks can be a mechanism for protecting wealth in a more substantial way than just CDs/T-Bills, etc. But ultimately, a basket of stocks not going to be able to return more than the underlying economy would. (ie - The GDP)

*headshake* The retirement people would have us believe we can invest our way to great wealth/a sure retirement. But if that were really the case, they'd keep their knowledge to themselves instead of offering services that encourage people to save like crazy using their products. :(

May 14, 2013 6:56 PM
 

bobi said:

I agree with frugalfun about the index funds and I would add that if Maggie wants to diversify and buy a few stocks on the side, go with DRIPs...I'm sure you'll have a chapter about them. I've had great success with DRIPs and highly recommend them.

May 14, 2013 7:37 PM
 

haverwench said:

"Part of the reason why this is a tough question to answer is because the answer depends somewhat on you and your personal investing style and risk tolerance."

Really? I would have said it's an easy question to answer: go with the fund. Do NOT, repeat NOT, try to pick individual stocks. If you think you can pick stocks that will outperform the market, you're wrong. Even if you were a professional financial planner with years of experience, you still wouldn't be able to do it. Choose a fund. Ideally an index fund. Don't try to outperform the market as a whole. That's the way to get burned.

Of course, that's more or less the advice you did give her--but I wouldn't have bothered to qualify it.

@frugal_fun:

"*headshake* The retirement people would have us believe we can invest our way to great wealth/a sure retirement. But if that were really the case, they'd keep their knowledge to themselves instead of offering services that encourage people to save like crazy using their products. :("

Why, whatever for? How could it possibly benefit them to have *fewer* people investing in the market? The market only goes up when *more* people invest.

May 14, 2013 10:58 PM
 

frugal_fun said:

"Why, whatever for? How could it possibly benefit them to have *fewer* people investing in the market? The market only goes up when *more* people invest."

Many financial planners and all the stock brokerages are dependent on people buying mutual funds/stocks for a living. The more stocks/funds you buy/trade, usually the more money they make. Quite often, if you listen to their rational for buying stocks/mutual funds, it's about how much wealthier you'll be in 5/10/20/30 years. However, their paycheck is usually quite disconnected from how the market is doing.

Unfortunately, my line of thinking about that situation goes like this: Why would you be the business of trading/selling stocks if you could make out like a bandit by simply buying it??? (Appreciation of individual stocks does not require masses of investors - only the broad indexes partly rely on overall market participation as far as I can tell.)

Anyway, if the appreciation/dividends were that crazy good and it's such a such a sure thing, wouldn't you just buy as much for yourself as possible and call in sick for the rest of your life? I know I would. And how many people have become very wealthy via shrewd stock purchases alone? I can't think of any really, although I do know people who have lost their shirts. :(

May 15, 2013 7:55 PM
 

haverwench said:

"Appreciation of individual stocks does not require masses of investors - only the broad indexes partly rely on overall market participation as far as I can tell."

But the more people there are buying it, the more the price goes up. That's simple supply and demand. If you think a stock is a hot stock and you're putting loads of money into it, it's in your interest to persuade everyone else to put loads of money into it as well. (And then sell before they do.)

I'm not arguing with the basic premise that the best way to make a fortune in the market is to be a broker so that you get your cut off the top regardless of whether the stock goes up or down. I'm just saying that someone who actually does believe in a particular stock/bond/fund has no reason to "keep it to himself." (Well, once he's already bought his shares, that is. Up till then he might keep mum to keep the price low. After that, though, he has every reason to spread the news and bump the price up.)

May 16, 2013 7:24 AM

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