Editor's Note: This story originally appeared on SmartAsset.com.
When managing your nest egg in retirement, there are a number of decisions to make surrounding which withdrawal rate to use and how to rebalance your portfolio. Perhaps the most key, though, is answering what types of investments you should make after you’ve left the workforce.
A major strategic decision in this regard hinges on whether retirees should veer toward safer income investing or wealth investing, which has the potential for more robust rewards. As far as retirees are concerned, income investing is a much better choice in terms of ensuring your money lasts through your golden years, according to a July study from Dimensional Fund Advisors.
The following will explain the difference between these two approaches and inform you about how you can use this information to maximize your retirement savings and stave off the erosion of your funds from inflation.
Wealth-Focused Investing Versus Income-Focused Investing
While there are many different types of investment strategies, two of the most common are wealth-focused investing and income-focused investing.
Wealth-focused investing, also known as growth investing, relies on stock market gains to increase investor capital. Investing in common stock is an example of wealth-focused investing. If an investor buys a share of a company for $100, for example, and sells it when it is worth $300, he’s added $200 worth of wealth to his portfolio, all through the growth of the market.
Income-focused investing, on the other hand, targets investments that will create guaranteed money for your portfolio. Income-focused investing is often thought of as a less risky investment, but with it comes less potential for big rewards. Buying corporate bonds is a type of income investing. In this scenario, you buy a bond from a company, which essentially means you lend the firm money. You then get paid back with interest over a period of time.
Again, there isn’t the potential for huge windfalls that come with wealth investing, but you are guaranteed a certain income. Stocks with dividends are a way of combining wealth and income investing: There is the potential for big growth from the stock, but you’ll also see a dividend payment, money paid to stockholders either monthly, quarterly or annually.
Research Shows Income Investing Is Safer for Retirees
Dimensional Fund Advisors published a study that compared three bad investment scenarios. These include poor stock market returns, inflation increases and interest rate decreases. The study concluded that retirees who take a wealth-focused approach to investing in their retirement years face much higher risks than those relying on income investing.
When comparing both types of investors, Dimensional imagined a scenario where both make regular contributions to retirement accounts starting at age 25 and both retire at 65, with all money being invested in stocks at the beginning of their savings and gliding down to an eventual landing point with safer investments in the mix like bonds. In this simulation, Dimensional expected both types of investors to plan for a 30-year retirement.
The first investor ends up at 65 with a portfolio that is 50% equities and 50% short-term nominal bonds. The second investor ends up at 65 with a portfolio that is 25% equities and 75% fixed-income investments. From there, Dimensional ran a “retirement stress test” where a number of economic conditions were applied to the hypothetical portfolios to see how they fared.
For all scenarios, the portfolio focused on wealth ran out of assets by age 85 5.7% of the time, and by 95 30.1% of the time. By contrast, the portfolio with an income-focused investment failed just 0.1% of the time by age 85 and 20.2% of the time by 95.
Inflation and Retirement Investing
Inflation, simply defined, is a market-wide increase in prices of goods and services, which results in money having less purchasing power. While inflation impacts everyone who participates in a market, it does have the potential to have an even bigger impact on retirees who are no longer actively earning income, as the money they have saved becomes less and less valuable as the years go by, meaning their savings will cover fewer expenses.
The Dimensional study specifically looked at how wealth-focused and income-focused portfolios would fare if there were unexpectedly high inflation. High inflation results in an 8.4% failure rate by age 85 for the wealth-focused portfolio, while the income-focused portfolio still fails just 0.1% of the time. By 95, a wealth-focused portfolio is running out of money 36.3% of the time when there is higher-than-expected inflation, while the failure rate for an income-focused portfolio stays at 20.2%.
The Bottom Line
You have a lot of choices to make when you’re saving for retirement and managing your investments in retirement itself. One major decision revolves around how you’ll build your portfolio once the active earning portion of your life is done and you are merely trying to preserve your wealth so it lasts you until you’ve shuffled off this mortal coil. This study presents strong evidence that an income-focused portfolio is the option most likely to get you through your life without a major catastrophe, so make sure to consider that when planning your investments during retirement.
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