Funding your own retirement is intimidating. Many of us feel unprepared for the task of managing our money, making the job doubly difficult. And yet, for a great many people, there’s no choice.
Like it or not, our ability to live comfortably in old age is up to us. Our futures depend on what we do today and tomorrow.
If you want to dive deeply into it, retirement saving and investing can be complex. But most of us aren’t interested in becoming experts. For a simple, manageable approach, check out these five steps.
Step 1: Use your age to decide what to put in stocks
Over time, stocks have produced higher returns as an investment — although, as financial product ads warn, past performance doesn’t predict future results. Retirement savers often invest in stocks by buying stock mutual funds.
Investors might need a rule of thumb to decide how much of their portfolio to put in stocks. Money Talks News founder Stacy Johnson favors this formula:
- Subtract your age from 100.
- Invest the remainder as a percentage in stocks.
How it works: If you’re 45, subtract 45 from 100, which leaves 55. So, invest 55 percent of your portfolio in stocks.
Some experts think the mix should change now that Americans are facing longer retirements. CNN Money’s Ultimate Guide to Retirement says:
[W]ith Americans living longer and longer, many financial planners are now recommending that the rule should be closer to 110 or 120 minus your age. That’s because if you need to make your money last longer, you’ll need the extra growth that stocks can provide.
So, if you’re 45, subtract 45 from 110, leaving 65. Invest 65 percent of your portfolio in stocks. Or, subtract 45 from 120, leaving 75, and put 75 percent of your portfolio in stocks.
You get the idea. The only trick is to choose the equation that you think is most closely aligned with your risk tolerance, and your health and family history — in other words, your life expectancy.
Step 2: Find your tolerance for risk
Stocks offer a better chance of growing your money, but they also involve more risk. In general, the stock market has climbed since the end of the recession. But don’t let that make you complacent. Investing can be a gut-churning ride.
Here’s the puzzle retirement savers face: If you keep all of your money in cash or low-risk investments, you’ll earn practically nothing. You may even lose money to inflation. More risk can mean a chance for higher returns.
Understanding your tolerance for risk helps you decide how to invest and lets you sleep well at night. To explore your investment risk tolerance, use the Rutgers University Cooperative Extension investment risk questionnaire.
The proportion of your savings that you put in stocks is up to you and your comfort level with risk. Not everyone uses the formulas above. They’re just a place to start. For some investors, putting half or more of your savings in stocks feels too risky. If that’s you, don’t do it.
Step 3: Listen to Warren Buffett and pick a stock fund
Many investors prefer a simple way to invest: They buy shares of index funds, which are often managed by computers. These mimic the performance of a particular group of stocks or bonds. The Vanguard 500 Index Fund, for example, mimics the performance of Standard & Poor’s 500 stock index.
Index funds are cheaper to own than managed funds, which are managed by human experts. Even better, the track record of index funds is often at least as good as the performance of actively managed funds.
A report in The New York Times cited a series of annual S&P Dow Jones studies that found “that over extended periods, the average actively managed fund lags the average index fund.” Some active managers do better than index funds, but it’s hard for most of them to maintain that edge over time, the report says.
Index fund balances soared in spring 2014, when legendary investor Warren Buffett disclosed publicly that he wants most of his money put in a stock index fund after he dies. The Wall Street Journal reported:
The billionaire wrote in his closely watched letter to shareholders of his company, Berkshire Hathaway Inc., that he believed most people would be well-served by following the investing instructions in his will.
Mr. Buffett, 83 years old and with a net worth of $66 billion, wrote that he advised his trustee to “put 10 percent of the cash in short-term government bonds and 90 percent in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.)”
Step 4: Diversify
A carefully chosen diverse set of investments helps cushion you against losses from stocks. The U.S. Securities and Exchange Commission says:
The practice of spreading money among different investments to reduce risk is known as diversification. By picking the right group of investments, you may be able to limit your losses and reduce the fluctuations of investment returns without sacrificing too much potential gain.
Pick your stock market investments first. For the remainder of your money, Money Talks News founder Stacy Johnson suggests dividing it in half: Put one-half into a low-cost intermediate bond fund and the rest into a money market deposit account or other insured fund.
Bonds pay considerably lower returns than stocks over time, but they are typically safer. Investors traditionally have purchased bonds to keep a portion of their money in a safe haven in case stock prices fall. Bonds often increase in value when stocks fall.
Bank deposits and money market deposit accounts are insured by the federal government, usually up to $250,000 in losses. Money market mutual funds — which contain instruments like government bonds, Treasury bills and certificates of deposit — are not federally insured. For a full rundown of which accounts are government-insured, and which are not, check this Federal Deposit Insurance Corp. link.
Step 5: Consider your investment time horizon
The proportion of money you put in stocks also should depend on how soon you’ll need your cash. That’s why the rules of thumb above take your age into account. You can tolerate more risk if you know you have 20 years to make up any losses. If you’re planning to retire and will need money within five years, you’re better off limiting your risk.
What is your approach to retirement savings? Share with us in comments below or on our Facebook page.
Kari Huus contributed to this post.
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