Remember how, in Chapter 6, Ken was able to create a nest egg for himself by selling his half of the family business to his brother?
That’s nice if you’re in that same situation, or if you receive a golden parachute when you retire or otherwise leave your job. But let’s say that neither of those options are available to you. You need to fund your retirement—in whatever form it takes—by building up your savings over time, dollar by dollar. Then, when your earning power begins to decrease, as it likely will someday, you’ll have enough reserves to keep yourself and your family in the circumstances to which you’re accustomed.
To put it very plainly, as you save for retirement you want to amass the biggest pile of assets that you can. More savings equals more confidence and room to breathe. Less savings equals less confidence and more restrictions.
But saved dollars are slippery things. They’re not called “liquid” for nothing! You have to know how to both save them and—just as importantly—keep them from slipping away. When saving and investing for retirement, four factors are key in determining how much you’re going to have when you blow out ninety candles on your birthday cake.
- Time - The number of years during which you save.
- Amount - How much you save per year.
- Rate of appreciation - How much your savings can grow through interest and investments.
- Rate of depreciation - How much you may lose from inflation, taxes, and bad investments. Our discussion assumes no early withdrawals from your retirement accounts.
Numbers 1, 2, and 3 should be as large as possible.
Number 4 should be as small as possible.
“Whoa!” I can hear you say. “Do you mean I can lose money even though I’m saving it?”
Yes, in some circumstances you can either lose actual dollars (taxes, market fluctuation) or your dollars can lose their value (inflation). This highlights the importance of your retirement investment strategy.
To explain what that means, let’s draw a sharp contrast between two extreme investment approaches.
1. Cash in the Mattress
Under this plan—if you can call it that—you take an amount of cash, say $200 per week, and you stuff it into your mattress. You leave it there, untouched.
The math is easy. After one year, you will have $10,400. After ten years, you will have $104,000. If you do it for thirty years, you will have $312,000 in cash stuffed into your mattress.
What’s wrong with this scenario?
Nothing, really. But there are risks and costs.
The obvious risk is that cash is a physical thing—pieces of paper—that can be damaged or stolen. A fire in your house would wipe out your savings, a mouse could eat it, or a thief could steal it.
The less obvious risk is that inflation will decrease the value of your cash. In terms of its buying power, your dollar is worth only what society agrees it’s worth, and historically, over time, the buying power of the dollar has only gotten smaller.
Since the early 20th century, inflation has made the value of the dollar decline dramatically. According to the Consumer Price Index (CPI), the first measurements of inflation began in 1913, with a baseline designation of $100. You can go online to any CPI inflation calculator and see how the buying power of the dollar has shrunk since then. By 1950, you would have needed $243.43 to buy the same goods that you could have bought in 1913 for $100. In 2000, you would have needed $1,739.39 to buy the same goods. By 2019, it was up to $2,553.29.
So, if you put $200 in your mattress in 1989, by the year 2019, those same paper dollars would be able to buy only about $100 in goods. Their value would have declined by half.
This is obviously not a good retirement savings strategy! While the risk is very low, the return is much too low to be acceptable. In fact, it’s a negative ROI. No one wants that.
Now let’s go to the other extreme—high risk, high return on your investment.
2. Speculative Investment
Let’s say you’re at a bar and your friend introduces you to Mr. Ponzi, who is the CEO of Super Energy Corporation, a Silicon Valley startup that’s developing a new fuel cell technology that converts ordinary seawater into automobile fuel. Ponzi promises the company has applied for lucrative patents, and he gives you a prospectus. The technology is exciting and the outlook for the company looks bright. Mr. Ponzi offers to let you come in “on the ground floor” for $1 million, which happens to represent your life savings. Mr. Ponzi promises you’ll double your money in a year. How could you say no? So, you invest your savings into Super Energy Corporation.
Sure enough, a few months later, Super Energy goes bankrupt and your investment is gone. You now have nothing.
Far-fetched? No. Statistics say that 90 percent of startups fail—not just in Silicon Valley, but everywhere. The list of big startup bankruptcies is long: LeSports (total disclosed funding $1.7 billion), Singulex ($219 million), Tink Labs ($125 million), Beequick ($110 million), and many more. Their backers lost significant chunks of their investments, if not everything.
It’s true that some speculative ventures succeed spectacularly. We all know the stories of Apple and Google, but there are others. For example, the $60 million that VC company Sequoia Capital put into WhatsApp turned into a $3 billion payday when the company was bought by Facebook.
The allure of high-risk, potentially high-ROI investments is understandable. But so is the comfort of keeping some cash in a mattress.
Risk vs. Reward
One rule of thumb in investing (and in life) is this: The lower the risk, the lower the reward. The higher the risk, the higher the reward. It’s been that way since the dawn of time, or at least since the days of the Great Tulip Bubble in 1637, when tulip prices crashed and investors lost huge fortunes.
So, as you craft your retirement remix, how should you save and invest your money to achieve the best blend of risk and reward?
Simple: You pursue a multi-faceted investment program with a range of risks and rewards.
On a scale of risk and reward, here are some broad investing choices. Please note that for simplicity, we’re not including investments in physical, non-liquid assets such as real estate, antiques, jewelry, and precious metals, although many people do invest in them. Technically, a traditional retirement account may be considered a non-liquid asset because if you convert it to cash, you’ll owe income taxes on the distribution (and, if you’re younger than 59 and-a-half, you may owe a penalty) and therefore its value is diminished; but since most people think of a retirement account as a form of cash, we’ll include it.
On a scale from low risk/low reward to high risk/high reward, here are three broad classes of investments:
1. Lower Risk/Reward (Cash)
When we say “cash,” we’re not necessarily talking about stuffing your mattress with greenbacks—that’s not an “investment.” Many forms of investments are considered “cash equivalent,” because they are very liquid, very safe, and offer a low yield.
Certificate of deposit (CD). There are many types of CDs, but generally, funds are held for a predetermined period of time, and periodic interest payments are made to the investor. The Federal Deposit Insurance Corporation (FDIC) insures CDs up to $250,000. Unlike bonds, which can be sold prior to the maturity date, if they’re held with a bank, the funds in a CD are locked in, and withdrawing the money may incur a penalty. This is not the case for CDs held with a brokerage, which permits selling on the secondary markets prior to maturity at a variable price.
Money market instruments. These very liquid investments pay variable interest rates. Examples of money market instruments include commercial paper (debt instruments issued by companies) and Treasury bills (T-bills). It’s a very short-term security, and usually has a maturity of less than six months. Money market accounts typically have a slightly higher interest rate return than a cash savings account.
Savings accounts. Money held in a savings account is insured by the FDIC, so unlike the cash in your mattress, you can’t lose it. But the interest rate on these accounts is minimal. Investors who want the option to access their money at any time but also require a slightly higher rate of return, may consider putting their cash in a high-yield savings account. These accounts can come with monthly maintenance fees and/or requirements to maintain a minimum balance.
These types of investments are the best place to secure an amount of funds for when:
- You need to access money quickly, such as for an upcoming project or for emergencies.
- You absolutely cannot afford to lose it.
2. Middle Risk/Reward
Here is where you enter the typical world of investing, and you’ll find a wide range of risk and reward. Some examples include:
Government bonds. The US Treasury offers several types of bonds with various maturities. They include savings bonds, Treasury notes (two to ten-year maturities), Treasury bonds (long maturity), and Treasury inflation-protected securities (TIPS), which are inflation-indexed bonds. States and municipalities can also issue bonds, as well. These types of investments rarely default, but they carry a higher level of risk than those listed above because they often have longer durations and are subject to interest rate risk until maturity.
3. Higher Risk/Reward
High-yield bonds. These are high-paying bonds, sometimes referred to as “junk bonds,” with a lower credit rating (and hence more risk) than investment-grade corporate bonds, Treasury bonds, and municipal bonds. Issuers tend to be startup companies or capital-intensive firms with high debt ratios.
Stocks. Investments in corporations run the gamut from low to high risk. Steady “blue chip” stocks that pay dividends include Lowe’s, Apple, Coke, Texas Instruments, and Costco. Riskier, more volatile stocks tend to be in certain industries, such as biotech.
Stock values are affected by the economy. During the bull market that began in March 2009, the US stock market as a whole rose 330% in ten years. When we enter a recession (which happens as part of overall business and market cycles) and the stock market falls, so could the value of your stock portfolio. Investing in stocks, whether individual companies or “packaged products such as mutual funds,” is a long-term strategy. It’s always my suggestion that folks focus on being an investor, not a trader.
The Investment Mix
Having an awareness of the relationship of risk to reward, you’ll probably want to create an investment and savings plan that takes your tolerance for risk into consideration. That said, it’s been my experience that you don’t actually know how much risk you can tolerate until you’ve experienced it – if you had money invested in 2008, you know what I mean. Ultimately, my suggestion is to begin with a plan for your goals, determine how much risk is necessary to be confident that you can reach them and then work with a professional to design a portfolio that can help get you from point A to point B with as little uncertainty as possible.
When it comes to developing your overall investment mix, or asset allocation, it’s important to be diversified – said differently, “don’t put all of your eggs in one basket.” Just remember, there’s a big difference between asset allocation and advisor allocation. If you have multiple advisors, and each of them recommended that you own stock in Amazon (for example,) you may not be as diversified as you think. It’s important to look at your investments cumulatively, not each account separately.
The investment mix—or asset allocation—typically changes as you get older and your years of decreased earnings approach, or your goal or circumstances change. At every age, you want the optimum mix of risk vs. reward, and it’s important to regularly review your plan and your investment strategy to make sure that they remain aligned.
Most often, the key is having the right mix of stocks, bonds, and cash. Pick your asset allocation wisely, and it will do the work for you. Of course, if you have expertise in another area—for instance, if you own income-producing commercial properties such as apartment buildings—then that’s something that can factor into your overall planning.
Generally, investors who are younger can tolerate more risk, because the assumption is that if a young person loses money due to market volatility, they have many more earning years in which to make it up. On the other hand, if you’re eighty years old, you may want to be more conservative.
Regardless of your age or life stage, selecting the right mix of investments to be confident that you can reach your goals is key. You may own the same types of investments (even specific stocks in your eighties that you did in your twenties, but the ratio could change over time to suit your overall circumstances. Much like the rest of life, portfolios often make slow, gradual changes over time, rather than more drastic shifts from one direction to another.
Investing involves risk and you may incur a profit or loss regardless of strategy selected, including diversification and asset allocation. Holding stocks for the long term does not ensure a profitable outcome. Investing in stocks always involves risk, including the possibility of losing one's entire investment. This is not a recommendation to purchase or sell the stocks of the companies mentioned. This is not a recommendation to purchase or sell the stocks of the companies pictured/mentioned in this chapter.
The above article originally appeared as a chapter in The Retirement Remix and is reprinted with permission from the author Chip Munn. No parts of this article may be reproduced without correct attribution to the author of this book.
You can find the full book here.