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So you spent some of your best years mastering your trade. Now you have finally reached a point in your life where you have disposable income. Most of us have no experience with the investment world. It can be quite daunting to formulate a plan that will one day allow you to retire comfortably. In an era when it is not wise to depend on Social Security for your retirement, how does one start a sensible plan to build a nest egg?
First and foremost, if you have not already started saving for retirement – start NOW. Savings has to be one of the easiest things to delay. There is always a reason to spend money now instead of socking it away for the future. But it's only through the magic of compounding and appreciation that money grows. That means get money in the game and keep it in the game for the long term.
Before you decide where to invest your money, you should get your financial house in order. Things like student loans, credit card debt and auto loans whose interest is not tax deductible should most likely be paid first. It does not make financial sense to pay others a higher rate than you can reasonably expect to earn from your investments. Also, there is a peace of mind that comes with getting a handle on your debt. With that being said, let's outline some basic principles of investing that you should consider when formulating a plan to build wealth for retirement.
In what assets you put your money most likely has the biggest impact on how fast your money grows. In general, the less volatile the investment class, the lower the rate of return will be. Since this money is for the long term, you should not get fixated on short term fluctuations. Your tolerance for market volatility will maximize investment growth for the long term. Traditionally, the primary asset classes investors choose are stocks (most volatile), bonds (less volatile) or cash (least volatile). Most investors have no business holding individual bonds and are likely better off investing in mutual funds or exchange traded funds (ETF) for stocks as well. How much of your portfolio should be in stocks or bonds?
One rule of thumb says 100 minus your age is the percentage you should have in stocks. For example, if you are 40 years old, a portfolio of 60 percent stocks and 40 percent bonds would fit this rule. Some would say that this is on the conservative side and you should consider 110 to 120 minus your age to determine the share of equities in your portfolio. If you are having trouble deciding how to balance your portfolio, then consider a target mutual fund or ETF. These are instruments targeted at retirement in a certain year and gradually adjust the fund accordingly as the target date approaches. For instance, a target fund 2020 is going to be heavily weighted in bonds and cash, while a target fund of 2060 is going to be made up mostly of stocks.
Someone probably told you early on, "Don't put all your eggs in one basket." That's not only good advice for life, but is also one of the greatest ways to reduce the risk of your portfolio. We have heard of people getting rich by putting all their money in an individual stock. You tend to hear a lot more about that than those who lost everything by investing in individual stocks. While the markets reward risk over the long term, they do not reward unnecessary risk. There is no reason to take on specific risk, that is the risk of investing in one individual stock or sector of the market. Again, mutual funds and ETF's are a good way to start a diversified portfolio. To be well diversified, you should be invested in several sectors of the economy with exposure to both US and foreign stocks.
And let's not forget about Father Time. You need to diversify investment times as well. As markets fluctuate, it is very difficult to pick the best time to get in and out of the market. Dollar cost averaging, the practice of investing at given time intervals, helps smooth out investing in markets that go up and down.
Cost of Investing
Pay close attention to the expenses of any fund in which you invest. Actively managed funds, those where a fund manager is adjusting the fund with the goal of outperforming the market, tend to have the highest costs. It takes money to pay the fund manager and transactions costs are usual higher than a passively managed or index fund. In my opinion, active money management is a loser's game. It is hard enough to outperform the market, then to beat the market by enough to cover the costs of active management is even harder. Sure, a certain percentage of actively managed funds will outperform the market each year, but most won't in the long term. By choosing funds that seek to follow a market index, you will lower investment costs.
In which accounts to hold which investments is one of the least talked about pearls of investing. In general, there are two types of accounts: taxable and tax deferred. In taxable accounts taxes are due on dividends and capital gains the year they are realized. Always maximize your contributions to tax deferred accounts first. Then use your taxable accounts for things like stocks, especially those that do not pay dividends as there is no taxable event until that stock is sold. This means if you hold stocks in a taxable account and they appreciate, it will be tax free until the sale of the stock, at which time capital gains tax will come into play. Even if the stocks pay dividends or you decide to sell a stock that you have held longer than one year, the current tax rates are lower than if it where monthly bond dividends. In tax deferred accounts, on the other hand, dividends go untaxed until the time of withdraw. Examples of tax deferred accounts are 401K's and Traditional IRA's. Holding things like bonds that pay monthly dividends in these types of accounts delays taxes and lets that money work for you.
While far from a comprehensive investment guide, my hope is that this article will get you on your way to a prosperous investment strategy. Remember that all investment carries risk and loss of principal is possible.