Investing for Retirement

Making decisions about your retirement account can
seem overwhelming, especially if you feel unsure
about your knowledge of investments. However, the
following basic rules can help you make smarter
choices regardless of whether you have some
investing experience or are just getting started.
Don’t lose ground to inflation
It’s easy to see how inflation affects gas prices,
electric bills, and the cost of food; over time, your
money buys less and less. But what inflation does to
your investments isn’t always as obvious. Let’s say
your money is earning 4% and inflation is running
between 3% and 4% (its historical average). That
means your investments are earning only 1% at best.
And that’s not counting any other costs; even in a
tax-deferred retirement account such as a 401(k),
you’ll eventually owe taxes on that money. Unless
your retirement portfolio at least keeps pace with
inflation, you could actually be losing money without
even realizing it.
What does that mean for your retirement strategy?
First, you’ll probably need to contribute more to your
retirement plan than you think. What seems like a
healthy sum now will seem smaller and smaller over
time; at a 3% annual inflation rate, something that
costs $100 today would cost $181 in 20 years. That
means you’ll probably need a bigger retirement nest
egg than you anticipated. And don’t forget that people
are living much longer now than they used to. You
might need your retirement savings to last a lot longer
than you expect, and inflation is likely to continue
increasing prices over that time. Consider increasing
your 401(k) contribution each year by at least enough
to overcome the effects of inflation.
Second, you need to consider investing at least a
portion of your retirement plan in investments that can
help keep inflation from silently eating away at the
purchasing power of your savings. Cash equivalents
may be relatively safe, but they are the most likely to
lose purchasing power to inflation over time. Even if
you consider yourself a conservative investor,
remember that stocks historically have provided
higher long-term total returns than cash equivalents
or bonds, even though they also involve greater risk
of volatility and potential loss.
Invest based on your time horizon
Your time horizon is investment-speak for the amount
of time you have left until you plan to use the money
you’re investing. Why is your time horizon important?
Because it can affect how well your portfolio can
handle the ups and downs of the financial markets.
Someone who was planning to retire in 2008 and was
heavily invested in the stock market faced different
challenges from the financial crisis than someone
who was investing for a retirement that was many
years away, because the person nearing retirement
had fewer years left to let their portfolio recover from
the downturn.
If you have a long time horizon, you may be able to
invest a greater percentage of your money in
something that could experience more dramatic price
changes but that might also have greater potential for
long-term growth. Though past performance doesn’t
guarantee future results, the long-term direction of the
stock market has historically been up despite its
frequent and sometimes massive fluctuations.
Think long-term for goals that are many years away
and invest accordingly. The longer you stay with a
diversified portfolio of investments, the more likely
you are to be able to ride out market downturns and
improve your opportunities for gain.
Consider your risk tolerance
Another key factor in your retirement investing
decisions is your risk tolerance–basically, how well
you can handle a possible investment loss. There are
two aspects to risk tolerance. The first is your
financial ability to survive a loss. If you expect to need
your money soon–for example, if you plan to begin
using your retirement savings in the next year or
so–those needs reduce your ability to withstand even
a small loss. However, if you’re investing for the long
term, don’t expect to need the money immediately, or
have other assets to rely on in an emergency, your
risk tolerance may be higher.
The second aspect of risk tolerance is your emotional
ability to withstand the possibility of loss. If you’re
invested in a way that doesn’t let you sleep at night,
you may need to consider reducing the amount of risk
in your portfolio. Many people think they’re
comfortable with risk, only to find out when the market
takes a turn for the worse that they’re actually a lot
less risk-tolerant than they thought. Often that means
they wind up selling in a panic when prices are
lowest. Try to be honest about how you might react to
a market downturn, and plan accordingly.
Remember that there are many ways to manage risk.
For example, understanding the potential risks and
rewards of each of your investments and its role in
your portfolio may help you gauge your emotional risk
tolerance more accurately. Also, having money
deducted from your paycheck and put into your
retirement plan helps spread your risk over time. By
investing regularly, you reduce the chance of
investing a large sum just before the market takes a
Integrate retirement with your other
financial goals
Make sure you have an emergency fund; it can help
you avoid needing to tap your retirement savings
before you had planned to. Generally, if you withdraw
money from your retirement plan before you turn
59½, you’ll owe not only the amount of federal and
state income tax on that money, but also a 10%
federal penalty (and possibly a state penalty as well).
There are exceptions to the penalty for premature
distributions from a 401(k) (for example, having a
qualifying disability or withdrawing money after
leaving your employer after you turn 55). However,
having a separate emergency fund can help you
avoid an early distribution and allow your retirement
money to stay invested.
If you have outstanding debt, you’ll need to weigh the
benefits of saving for retirement versus paying off that
debt as soon as possible. If the interest rate you’re
paying is high, you might benefit from paying off at
least part of your debt first. If you’re contemplating
borrowing from or making a withdrawal from your
workplace savings account, make sure you
investigate using other financing options first, such as
loans from banks, credit unions, friends, or family. If
your employer matches your contributions, don’t
forget to factor into your calculations the loss of that
matching money if you choose to focus on paying off
debt. You’ll be giving up what is essentially free
money if you don’t at least contribute enough to get
the employer match.
Don’t put all your eggs in one basket
Diversifying your retirement savings across many
different types of investments can help you manage
the ups and downs of your portfolio. Different types of
investments may face different types of risk. For
example, when most people think of risk, they think of
market risk–the possibility that an investment will lose
value because of a general decline in financial
markets. However, there are many other types of risk.
Bonds face default or credit risk (the risk that a bond
issuer will not be able to pay the interest owed on its
bonds, or repay the principal borrowed). Bonds also
face interest rate risk, because bond prices generally
fall when interest rates rise. International investors
may face currency risk if exchange rates between
U.S. and foreign currencies affect the value of a
foreign investment. Political risk is created by
legislative actions (or the lack of them).
These are only a few of the various types of risk.
However, one investment may respond to the same
set of circumstances very differently than another,
and thus involve different risks. Putting your money
into many different securities, as a mutual fund does,
is one way to spread your risk. Another is to invest in
several different types of investments–for example,
stocks, bonds, and cash alternatives. Spreading your
portfolio over several different types of investments
can help you manage the types and level of risk you
Participating in your retirement plan is probably more
important than any individual investing decision you’ll
make. Keep it simple, stick with it, and time will be
your best ally