3 Key Rules

Last updated: April 8, 2016

The 3 Rules to Retire By

Rule 1: Time is on Your Side

Retirement is a long-term goal. Whether you’re just starting your career or counting down your final years until retirement, one of your key investment allies is the “magic of compounding”. Your interest earns interest and profits build on profits automatically.  

 
  • For example, let’s say you invest $10,000 in an investment that pays an 8% annual return.

    • You’ll have $10,800 at the end of year one.

    • After five years, your $10,000 will have grown to $14,700

    • $31,700 after 15 years

    • $68,500 after 25 years, even if you never add another dime to the pot.

But don’t stop there! Your nest egg will grow more quickly if you continue to add to it year after year.

  • Ideally, you want to save enough to replace 80% or more of your preretirement income.  You do this through a combination of social security benefits, personal savings and other sources of retirement income, such as a pension or a part-time job.

To achieve that goal, you should start saving for retirement with your first job. You should ultimately aim to contribute 15% of your gross income. (This includes any employer contributions.)

In the meantime, don’t worry about the short-term ups and downs of the stock market.

  • Even huge swings, such as those that occurred in the bear market that began in 2007 and lasted through early 2009.

  • You’re a long-term investor who will benefit from putting time to work for you.

    • That means not cashing out your investments when the market tanks; not borrowing from your retirement account to fund short-term needs, such as buying a car or taking a vacation.

    • Your goal is to build as big a retirement kitty as possible—without taking unreasonable risks.

      • The key word here is “unreasonable” and leads us to rule #2.

Rule 2: All Investing Involves Some Risk

Investing is a bundle of trade-offs between risk and reward. A willingness to take some risk with your money today provides you with the chance to earn a bigger return in the future. 

In fact, the hidden risk of retirement investing comes from not taking enough risk.

  • By stashing all of your money in super safe investments, such as bank certificates of deposit and money-market funds, you forfeit your chance at bigger gains.

    • In turn, you sacrifice a more secure retirement.

  • In effect, you swap one kind of risk—investment volatility—for two others:

    • The risk that your nest-egg performance won’t keep up with inflation or that you’ll outlive your money.

It can be nerve-racking to stick to your long-term investment goals during times of severe market volatility.

  • Keep in mind that even if you retire tomorrow, you don’t need all of your money tomorrow.

  • Even in retirement, you’re still a long-term investor.

    • You’ll need to keep a portion of your assets invested for growth to carry you through a retirement. Retirement could last 20 years or more.

The real losers during the latest market meltdown were those who panicked and bailed out as the market fell, locking in losses. Those who continued to invest throughout the downturn were rewarded.

  • They scooped up bargain-price shares that grew more valuable as the market rebounded.

    • That’s just one example why time in the market is the best strategy for long-term investors.

    • Trying to time the market by constantly buying and selling is not a good long-term strategy.

The more time you have to reach your retirement goal, the more investment risk you can afford to take.

  • The best approach is to start out with higher-risk investments, such as stocks or mutual funds that invest in stocks, when you’re in your twenties, thirties and forties.

  • As you near retirement (in your fifties and sixties), gradually reduce your risk level by shifting some of your money into more-conservative investments, such as bonds or bond funds.

If you are close to retirement and your savings haven’t grown fast enough to meet your anticipated retirement-income needs, you might be tempted to increase your risk in hopes of achieving a higher return. Don’t.

  • A better solution is to delay retirement a few years until you’ve saved more and built the nest egg you need. And delaying retirement has a double-barreled financial benefit:

    • The longer you wait to claim your Social Security benefits, the bigger they will be. (Until they reach the maximum value at age 70.)

    • Plus, the later you retire, the fewer years your nest egg will need to support you.

Rule 3: Diversification Works

By dividing your retirement money among several types of investments—that is, diversifying your portfolio—you can reduce your risk and increase your opportunity for higher returns.

  • Because no investment performs well all the time, when one is down, something else is likely to be  up.

(The stock market’s 2007–09 collapse, coupled with an economy-wide credit crunch, created a rare perfect storm in which virtually every investment class declined. But by the end of 2009, many investors had recovered most of their losses.)

*The information on this page is credited to IPT and Kiplinger. Their original materials are made available by the Kansas Securities here.