Have you noticed how difficult it is to determine what you should eat, based on news articles? One day eggs can kill you, the next day they're the secret to staying slim. The same can be said for retirement planning. There is so much information—some of it contradictory—that planning with confidence seems impossible. Unfortunately, when faced with these difficult decisions, people let the size of the problem overwhelm them and they ignore it. They come to regret it later in life.
The average person really only needs to know a few terms and several rules-of-thumb to invest wisely. The purpose of this article is to relay the most essential elements of retirement planning as succinctly as possible. You will need to work with a money management company (as a professor, I have TIAA-CREF) to execute your plan, but this article gives you the power to talk to them intelligently, and ensure they are executing the right plan for you. I hope it helps you thrive in life.
There are thousands of different types of investments, but they can all be grouped into one of three categories. These three investments are short-term reserves, bonds, and stocks.
Three kinds of investments
- Short-term reserves—very safe, short-term investments with a guaranteed return. These include savings accounts, certificates of deposit (CDs), and money market accounts. In return for lending your money for a certain period, you are guaranteed to be repaid a certain number of dollars. These are generally short-term investments, lasting as little as one day but generally not longer than a year.
- Bonds—similar to short-term reserves, except you loan the money for a longer period of time. You lend money and are promised to be repaid a certain number of dollars. There are many different types of bonds, some riskier than others. Both governments and businesses sell bonds, and they can be short-term or long-term, but usually longer than a year. Generally, they are riskier than short-term reserves but less risky than stocks. Though there are some risky bonds, unless they are referred to as something like junk bonds, they are reasonably safe investments.
- Stocks—partial ownership of a corporation, and so stockholders receive whatever is leftover of profits after lenders of short-term reserves (hereafter, reserves) and bondholders have been paid. When a company makes more money than usual, holders of reserves and bonds get paid the same amount but stockholders get larger profits. This is why stocks can make much more money than bonds and reserves—but stocks are riskier. When a company goes bankrupt, it is forced to first pay back all its holders of short-term reserves and bonds. Then, whatever is left over goes to stockholders. So stockholders can suffer the greatest losses, but they also reap the greatest rewards.
Nominal rate-of-returns on investments
What is a rate–of–return? It is the annual percent change in your investment funds. If $1,000 earns an annual rate–of–return of 10% (and these returns are always on an annual basis), after one year that $1,000 has turned into $1,000(1 + 0.1) = $1,100. If that $1,000 is allowed to earn 10% over two years, that initial $1,000 becomes $1,000(1 + 0.1) = $1,100 after one year and $1,100(1 + 0.1) = $1,200 after the second year.
A nominal rate-of-return is simply the actual rate-of-return in actual dollars, a return that has not been adjusted for inflation.
As a general rule, the riskier the investment the greater the average rate-of-return, as that is the reward for taking greater risk. Below is information about the performance of our three class of investments.
- Stocks—As shown below, stocks earn about a 10% nominal rate of return, though in past decades there is a considerable chance of taking a loss.(1)
- Bonds—Bonds are less likely to lose money, and when they do lose money they lose a lot less. Yet the average return is only about 6%, about half that of stocks.(1)
- Short-term reserves—These basically never lose money, but the average return in past decades is low. I think a safe assumption is a 3.5% return.2
Real rate-of-return
If your investments increase your wealth by 5%, but the cost of everything has also risen by 5%, you really haven’t gained any wealth, have you? Yes, you have more dollar bills, but each dollar bill buys less stuff, and in the end you can’t buy any more goods and services than you could before. This simple thought experiment shows why it is so important to adjust rates-of-returns for inflation, in order to calculate how much one’s wealth has really changed. We must convert these nominal returns to real returns to truly evaluate how well investments perform.
The chart(3) above shows that inflation can vary considerably. During the 1930’s it was even negative, as shown in the chart below, meaning prices fell during that period. Over the past 100 hundred the average inflation rate has been around 3%, so that seems a fairly logical assumption to use.(4)
Converting a nominal return into a real return is easy: just subtract the inflation rate from the nominal return. This means that if stocks earn an average nominal return of 10%, and the average inflation rate is 3%, the average real return for stocks is 10% - 3% = 7%.
Managing the three classes of investments over your working years
Video 1—The consequence of poor retirement planning
Throughout your working years you will likely invest in all three investment types, but your portfolio (meaning the percent of money invested in each category) will change as you age. When young, you will want to be aggressive and invest mostly in stocks, because stocks earn so much more money, and even if the stock market experiences trouble you can leave it in stocks until it recovers, and it always recovers. As you age, however, you will want to slowly evolve, purchasing less and less stocks and more and more bonds / reserves. To illustrate, perhaps after five years of working you invest 80% of your money in stocks, after ten years 60%, after fifteen years 40%, and five years before retirement stocks only comprise about 15% of your investments. The important thing is that stocks dominant your investments while you are young but play a decreasing role as you age, being a minority of your investments shortly before retirement.
When about five years away from retirement you should consider moving most of your money invested in stocks out of stocks and into bonds / reserves, so that even if the stock market tanks right before your retirement date you will be okay. You don’t want to end up like the person in the video above, who didn’t transition their money out of stocks as they approached retirement, and when the 2008 financial crisis hit, she lost most half of her retirement savings.
How to invest in stocks
Stocks are known for their riskiness, and many people think of investing in stocks as a form of gambling. Is this true? It depends. If you attempt to research companies and focus most of your investments on a few stocks, you are likely to do poorly. The average person should never try to pick stocks, because there are herds of smart investors who consume all their waking time monitoring markets, and they can spot a good stock faster than you. More importantly, when they spot a better performing stock, they purchase it immediately, and in the process bid up the price of the stock until it is no longer desirable. In fact, the average person should be indifferent between which stocks to purchase. Instead of picking stocks yourself you could hire an investment manager to do so on your behalf. The problem is that they charge high fees.
Video 2—If you can’t pick stocks better than Gorden Gekko (from the movie Wall Street), don’t even try
On the other hand, if you purchase small amounts of many, many different stocks, over a long period of time you are almost guaranteed a decent rate-of-return, higher than you would receive if you hired one of the best investment managers (once you subtract out their fees). You can never tell if a single corporation will make money, but the majority of corporations is almost guaranteed to make money—after all, that is there sole objective. This sounds impossible for a single person to do, but nothing could be easier. Go to Ameritrade or Vanguard and you can quickly purchase investments called index funds that do just this and pay very low fees (compared to investment managers). Many investments called exchange-trade funds mutual funds also allow this.
References
(1) Rate-of-return informatation is acquired from: Vanguard. Not dated. Vanguard portfolio allocation models [website]. Accessed January 19, 2015 at https://personal.vanguard.com/us/insights/saving-investing/model-portfolio-allocations.
(2) Based on a large variety of data.
(3) inflation.eu. Not dated. Historic inflation United States—CPI Inflation [webpage]. Accessed January 19, 2016 at http://www.inflation.eu/inflation-rates/united-states/historic-inflation/cpi-inflation-united-states.aspx.