Too many young people rarely—if ever—invest for their retirement years. Some distant date, 40 or so years in the future, is hard for many young people to imagine. But without investments to supplement retirement income (if any), when these people become retirees, they'll have a difficult time paying for life's necessities.
Smart, disciplined, regular investments in a portfolio of diverse holdings can yield good, long-term returns for retirement and provide additional income throughout an investor's working life.
One reason people don't invest is that they don't understand stocks or basic concepts like the time value of money and the power of compounding. But it's not hard to learn about these things. There are many easily available sources of investing information, from business publications like The Wall Street Journal and books aimed at beginning investors, to classes offered by civic groups and not-for-profit organizations.
But you've got to start investing early; the sooner you begin, the more time your investments will have to grow in value. Here we'll discuss a good way to start building a portfolio, and how to manage it for the best results.
- Time is your friend; the earlier you start investing, the better off you'll be at retirement.
- To reduce risk, diversify your portfolio.
- Minimize costs by investing in low-fee vehicles such as index funds.
Start saving as soon as you go to work by participating in a 401(k) retirement plan, if it's offered by your employer. If a 401(k) plan is not available, establish an Individual Retirement Account (IRA) and earmark a percentage of your compensation for a monthly contribution to the account. An easy, convenient way to save in an IRA or 401(k) is to create an automatic monthly cash contribution.
Keep in mind that savings accumulate and interest compounds without taxes only as long as the money is not withdrawn, and so it's wise to establish one of these retirement investment vehicles early in your working life.
Early Higher Risk Allocation
Another reason to start saving early is that the younger you are, the less likely you are to have burdensome financial obligations: a spouse, children, and a mortgage, to name a few. Without these burdens, you can allocate a small portion of your investment portfolio to higher-risk investments, which can return higher yields.
When you start investing while you're young—before your financial commitments start piling up—you'll probably also have more cash available for investments and a longer time horizon before retirement. With more money to invest for many years to come, you'll have a bigger retirement nest egg.
An Exemplary Egg
To illustrate the advantage of investing as soon as possible, assume that you invest $200 every month starting at age 25. If you earn a 7% annual return on that money, when you're 65, your retirement nest egg will be approximately $525,000.
However, if you start saving that $200 monthly at age 35 and get the same 7% return, you'll only have about $244,000 at age 65.
For those who do start investing late in life, there are a few tax advantages. Notably, 401(k) plans allow catch-up contributions for people 50 and older, as do IRAs.
The idea is to select stocks across a broad spectrum of market categories. This is best achieved through an index fund. Aim to invest in conservative stocks with regular dividends, stocks with long-term growth potential, and a small percentage of stocks with better returns or higher risk potential.
If you're investing in individual stocks, don't put more than 4% of your total portfolio into one stock. That way, if a stock or two suffers a downturn, your portfolio won't be too adversely affected.
Certain AAA-rated bonds are also good investments for the long term, either corporate or government. Long-term U.S. Treasury bonds, for example, are safe and pay a higher rate of return than short- and mid-term bonds.
Keep Costs to a Minimum
Invest with a discount brokerage firm. Another reason to consider index funds when beginning to invest is that they have low fees. Because you'll be investing for the long term, don't buy and sell regularly in response to market ups and downs. This saves you commission expenses and management fees and may prevent cash losses when the price of your stock declines.
Discipline and Regular Investing
Make sure that you put money into your investments on a regular, disciplined basis. This may not be possible if you lose your job, but once you find new employment, continue to put money into your portfolio.
Asset Allocation and Re-Balancing
Assign a certain percentage of your portfolio to growth stocks, dividend-paying stocks, index funds, and stocks with higher risk but better returns.
When your asset allocation changes (i.e., market fluctuations change the percentage of your portfolio allocated to each category), re-balance your portfolio by adjusting your monetary stake in each category to reflect your original percentage.
A portfolio of holdings in a tax-deferred account—a 401(k), for example—builds wealth faster than a portfolio with tax liability. But remember, you pay taxes on the amount of money withdrawn from a tax-deferred retirement account.
A Roth IRA also accumulates tax-free savings, but the account owner doesn't have to pay taxes on the amount withdrawn. To qualify for a Roth IRA, your modified adjusted gross income must meet IRS limits and other regulations. Earnings are federally tax free if you've owned your Roth IRA for at least five years and you're older than 59.5, or if you're younger than 59.5, have owned your Roth IRA for at least five years, and the withdrawal is due to your death or disability—or for a first-time home purchase.
The Bottom Line
Disciplined, regular, diversified investments in a tax-deferred 401(k), IRA or a potentially tax-free Roth IRA, and smart portfolio management can build a significant nest egg for retirement. A portfolio with tax liability, dividends, and the sale of profitable stock can provide cash to supplement employment or business income.
Managing your assets by re-allocation and keeping costs (such as commissions and management fees) low can maximize returns. The earlier you start investing, the better off you'll be in the long run.
Finally, keep learning about investments throughout your life, both before and after retirement. The more you know, the more your potential portfolio returns—with proper management, of course.