Successful investing in retirement really comes down to fundamental principles more that it is about finding the right mutual fund. Utilize these principles to drive your decisions and you’ll be successful. I’ll call these the Three keys to Retirement Investing. These are:
- Contribute early and regularly
- Take appropriate risks
- Delay withdrawals as long as possible
Over the next few posts, we’ll look at each of these keys and why they are important. Today we’ll look at the importance of contributing early and regularly.
Contribute Early and Regularly
Let’s look at one individual who contributes $500 per month to his/her 401k, starting at age 25, which is $6,000 per year. This is about the level of contributions that someone making $40,000-$60,000 per year in salary should be striving to make. Assuming they receive an annual percentage yield of 12% over the 40 years they are invested, their portfolio would grow something like this:
Now, understand that he/she would not see steady growth like this in the stock market. It would be ups and downs, with some years that make 50% and others that lose 30%. Assuming that a 12% APR was realized, however, the net effect would be the same: a retirement portfolio in the $5M to $10M range. Here, our investor only contributed $240,000 of the money over his working lifetime.
Now let’s assume our investor waited until age 45 to start investing, then put away $2,000 per month for the next 20 years, trying to make up for lost ground. His/her return would look like this:
Here our investor has invested $480,000, but only ends up with about $1.2 M in retirement funds. By starting early, our first worker invested half as much, but ended up with about five to seven times more.
Now, what about making regular contributions? Efficient market theory says:
“Everything known is priced into the markets instantly, leaving only random fluctuations when there is no news.”
This means that the price of stocks (and bonds, and other investments) includes all news and what is known at this moment. You may hear that Apple is coming out with a new iPhone and think it is a great time to load up on shares of Apple. The trouble is that everyone else has heard the same news and before you can push “buy” on your screen, the price of the shares have already risen.
Other price movements not connected to news are therefore just random, unpredictable noise. You might think that stocks are pricey since they’ve gone through a big run up, but that doesn’t mean that they won’t continue to go up for a while. Maybe great earnings will come in and suddenly the higher price of the shares will be justified. If you try to buy and sell stocks because you’re trying to time the markets, you’ll be right about 50% of the time since really you’re betting on a coin flip. the other 50% of the time you’ll be wrong.
The trouble is, most of the big market moves – the ones that result in returns of 12% per year averaged over many years – occur during really short periods of time. A big rally may last only a couple of weeks or even a couple of days. Miss out on a few of these big rallies, and you’ll earn 2% instead of 12%.
Buying in has the same issue. If you just dump a bunch of money in the stock market and walk away, you are just as likely to be buying in at a high point as a low point. Pick the wrong high point, like 1999, 2007, or 1929, and you can be waiting years before you get back to even. Instead, you want to be making regular contributions, whether you think the markets are pricey or cheap. That way you’ll be buying shares as they dip in price. Even if you buy during a period in which the markets are flat, your average buy price will be lower than the average market price because you’ll be buying more shares when they are lower in price than when they are higher.
Next time I’ll talk about risk and taking appropriate risks, given your time until retirement and other factors.
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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.