Staying on track with your retirement investments.
By James W. Hamilton, III
Investing for your retirement isn’t about getting rich quick. More often, it’s about having a game plan that you can live with for a long time. You wouldn’t expect to be able to play the piano without learning the basics and practicing. Investing for your retirement in the long term also takes a little knowledge and discipline. Though there can be no guarantee that any investment strategy will be successful and all investing involves risk, including the possible loss of principal, there are ways to help yourself build your retirement nest egg.
Compounding is Your Best Friend
It’s the rolling snowball effect. Put simply, compounding pays you earnings on your reinvested earnings. Here’s how it works: Let’s say you invest $100, and that money earns a 7 percent annual return. At the end of a year, the $7 you earned is added to your $100. That would give you $107 in your account. If you earn 7 percent again the next year, you’re earning 7 percent of $107 rather than $100, as you did in the first year. That adds $7.49 to your account instead of $7. In the third year with a 7 percent return, you’d earn $8 and have a total of $122. Like a snowball rolling downhill, the value of compounding grows the longer you leave your money in the account.
In effect, compounding can do some of the work of building a nest egg for you. The longer you leave your money at work for you, the more exciting the numbers get. For example, imagine an investment of $10,000 at an annual rate of return of 8 percent. In 20 years, assuming no withdrawals, your $10,000 investment would grow to $46,610. In 25 years, it would grow to $68,485, a 47 percent gain on the 20-year figure. After 30 years, your account would total $100,627. (Of course, these are hypothetical examples that do not reflect the performance of any specific investment and assume that no taxes are paid or withdrawals are made during that time.)
If your workplace savings plan contributions are made pretax, as most people’s contributions are, compounding really becomes a powerful force. Not having to pay taxes from year to year on either your contributions or the compounded earnings helps your savings grow even faster (though you’ll owe taxes on that money when you start withdrawing from your account). The value of compounded tax-deferred dollars is the main reason you may want to fully fund all tax-advantaged retirement accounts and plans available to you, and start as early as you can. Money invested in time offers the greatest potential for compounding to help produce a significant return. With time on your side, you don’t necessarily have to aim for investment home runs in order to be successful.
Diversify Your Investments
Asset allocation is the process of spreading your dollars across several categories of investments, usually referred to as asset classes. A basic asset allocation would likely include at least stocks, bonds and cash, or cash alternatives, such as a money market fund. The term “asset classes” also may refer to subcategories, such as aggressive growth stocks, international stocks, investment-grade corporate bonds and high-yield or “junk” bonds. Asset allocation is important for two reasons.
First, the mix of asset classes you own is a large factor—some say the biggest factor by far—in determining your overall investment portfolio performance. How you divide your money between stocks, bonds and cash can be more important than your choice of specific investments.
Second, by dividing your portfolio among asset classes that don’t respond to market forces in the same way at the same time, you can help minimize the effects of market volatility while maximizing your chances of long-term return. Ideally, if your investments in one class are performing poorly, assets in another class may be doing better and may help stabilize your portfolio.
Remember that during any given period of market or economic turmoil, some asset categories and some individual investments historically have been less volatile than others. Bond price swings, for example, have generally been less dramatic than stock prices. You can manage your risk to some extent by diversifying your holdings among various classes of assets, as well as different types of assets within each class. Taking steps that can help manage the amount of volatility you experience can help you stay with your game plan in the long term.
One of the benefits of participating in your workplace savings plan is that you’re automatically using an investment strategy called dollar cost averaging. With dollar cost averaging, you acquire shares of an investment by investing a fixed dollar amount at regularly scheduled intervals over time. When the price is high, your investment buys less; when prices are low, the same dollar investment will buy more shares. A regular, fixed-dollar investment should result in a lower average price per share than you would get buying a fixed number of shares at each investment interval.
The accompanying graph illustrates how share price fluctuations can yield a lower average cost per share through dollar cost averaging. In this hypothetical example, ABC Company’s stock price is $30 a share in January, $10 a share in February, $20 a share in March, $15 a share in April and $25 a share in May. If you invest $300 a month for five months, the number of shares you would buy each month would range from 10 shares when the price is at $30, to 30 shares by dividing your portfolio among asset classes that don’t respond to market forces in the same way at the same time, you can help minimize the effects of market volatility.