Investing when you’re twenty, or thirty, or forty is easy. Just invest regularly, buy mostly stocks, and don’t fool around with things. If the markets goes down, buy more. If the market goes up, buy more. The key is regular investment and maximizing your total returns by using growth stocks, which will do better than virtually any other investment if given ten or twenty years.
Things get a lot more tricky when you’re living off of your portfolio in retirement and need the money for day-to-day expenses. Being fully invested in stocks, unless you have four or five times what you need in your portfolio, would be very dangerous. It is very possible over any short period of time that a portfolio of growth stocks could lose nearly half of its value. Chances are good that it would climb back out of the hole and be humming again within a year or two, but when you need to eat today, that can offer little solace.
Some retirees do the opposite and try to use bank CDs to generate income for retirement. Those retirees have suffered over the last six years of low interest rates, but even when interest rates were higher and they were making more in terms of dollars they were still losing money to inflation since bank rates are always a percentage point or two below inflation. If you put the money in the bank, you’ll eventually start spending some of the principle. The rate of collapse of your portfolio will increase as you spend the money down since there will be less there to generate interest. With this strategy you can only hope to pass away before you run out of money. Otherwise, you’ll need to move in with relatives or spend the rest of your days in a spartan existence subsidized by the government.
William Baldwin makes a good point in Forbes this month in an article called A Rising Income Portfolio where he points out that if you have an income portfolio (bonds, for example) and spend all of the interest on expenses, while the level of income you’ll receive in absolute dollars will remain about fixed, because you only get the return of your principle as the bonds expire rather than an increase for inflation as you would see when investing in stocks, the buying power of your principle will decline each year. Do this for a long period of time and you’ll find it hard to generate enough income to pay for things, eventually needing to spend your principle and start the portfolio death cycle.
So, how do you create a portfolio that can last and provide you the needed income during retirement?
The first step is to start early.
A person retiring today with $1 M will find it hard to live thirty years past retirement without running out of money. Someone with $2 M will probably make it, but it could get a little dicey near the end as inflation eats away at spending power. $4 M would be a good goal since that would allow you to invest $2 M like a retiree and leave the other $2 M in stocks so that your wealth grows over your retirement. If you’re coming up to retirement age but still below $2 M in savings and still able to work, I’d keep working while you can since that both increases you savings and reduces the time you’ll need to live off of your savings.
Building up these kinds of sums takes time, however. If you’re just starting to work today, you’ll probably need $10 M or more at retirement to be comfortable. If you start putting money away with your first job it isn’t hard to do at all. Wait until you’re in your fifties and it becomes almost impossible.
Get more conservative as you approach retirement.
There are really two approaches to withdrawing money from your portfolio for expenses in retirement. The first is to simply sell off stocks and keep some cash in your portfolio. At retirement you’ll want at least a couple of years’ worth of cash if you’re relying on this approach. Three to five years’ worth would be better. One strategy would be to sell stocks during good years to replenish your reserves of cash, but let your stocks recover during bad years.
The other strategy is to use high yield investments, such as bonds and preferred stocks, to generate income for spending. The price of these investments may fluctuate, but even in bad times they tend to keep paying interest at a relatively stable rate. The issue is that your spending power will decline with time, so you’ll need to keep some stocks as well for growth. As time passes and you need more income, you can sell some stocks and purchase more income securities. You’d still want to keep some cash on hand to make sure you could pay bills between dividend and interest payments.
Don’t forget about growth.
As stated above, you really want to have enough money in your portfolio to have some investment in stocks which will grow with inflation. The more extra money you have, the better your life will be since you’ll be able to generate far better returns with the stock portion of your portfolio than the income portion. Just don’t expect returns to be predictable. It will be up 20% one year, down 15% the next, and so on. You’ll need to be opportunistic for when you sell and add to your cash and income securities.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.