Managing money in the account
By now I hope you've got a good idea of how to save money into the appropriate retirement account. Remember, most people will need to save about 10 percent of their salary in order to be able to provide for their retirement.
However, this assumes you're earning a good real return on your money. If you put all of your money into a money market account or certificates of deposit, you're basically treading water because most of your return will be eaten up by inflation.
To be able to retire at 65 while saving only 10 percent of your salary, your savings must grow faster than inflation. This means that you'll have to have a good chunk of your money in stocks.
I talk about asset allocation, market timing, diversification and other concepts in my tape on mutual funds, but let's talk generally about money management with retirement accounts.
Retirement money means long-term investments
Unless you're in your late 50s and near retirement, remember that the money in your retirement accounts is long-term money. You can accept some short-term risks in exchange for potentially higher returns.
This means investing in stocks because over time, stocks have performed much better than bonds, gold or almost every other asset.
Returns of stocks, bonds, bills and inflation
Over the past 70 years, stocks have provided an average return of 10 percent, long-term bonds about 5 percent, and short-term Treasury bills about 4 percent. Over that same period inflation has averaged about 3 percent per year.
And remember our discussion of compound growth. Over time, raising your investment return from 5 percent to 10 percent means tremendous payoffs down the road.
Still, investing in stocks is risky. In one day in October, 1987 the stock market lost 20 percent of its value, so you don't want to put money that you'll need tomorrow into stocks.
Why you can accept risks when you're young
When you're young, you can accept risk because your savings are few and you have an entire career to replace any lost assets.
Suppose you're 35 years old and you have retirement savings of $10,000. You invest in stocks, and suddenly lose 20 percent of your $10,000 portfolio. Although you may not be happy with your $2,000 loss, you can replace that loss within a year with $2,000 in new savings.
But what happens if you're 65, retired, and you lost $20,000 of a $100,000 portfolio. In this case you also lost 20 percent of your portfolio, but the total loss is much harder to replace.
The loss is harder to replace because the size of the loss is much larger, and at age 65 you can't replace the loss through work if you're already retired.
Invest your age in bonds, 100-age in stocks
So most people are able to accept more risk when they're young, but less risk when they're older. This means you should be willing to load up on stocks when you're younger, but sell them off as you age. A good rule of thumb is to take your age and invest that percentage in bonds, and the remainder in stocks.
So if you're 30 years old you should have 30 percent bonds and 70 percent stocks in your retirement account. If you're 55, increase your bonds to 55 percent and reduce your stocks to 45 percent.
You'll also want to rebalance your retirement money each year to maintain the right proportion of stocks and bonds. If the stock market is up but bonds are down, you should shift some of your money from stocks into bonds to keep your ideal ratio. This also has the advantage of forcing you to sell high and buy low.
This rule of putting 100 minus your age into stocks is actually conservative, but at almost any age you'll still need to put a good proportion of your assets into stocks. Unfortunately, many people are putting far too little into stocks.
Most people put too little into stocks
In the past, many investors put too much of their 401(k) or other retirement money into fixed income or bond investments. The most popular 401(k) investment was a so called Guaranteed Investment Contract, or GIC.
GICs are an insurance company product that are similar to certificates of deposit or bonds. I cover GICs in my tape on bond and fixed income investing. GICs have their place in a 401(k) account, but most younger investors should accept the risks of stocks and hope that stocks will continue to beat all other investments by a wide margin.
However, recent evidence shows that many 401(k) investors are putting too much money into their employer's stock. Although the company may give you a good deal on its stock, this is dangerous. If your company hits hard times you may lose your job and have your retirement fund lose most of it's value.
What does 401(k) plan offer in fund selection
Assets to not put into retirement accounts
Copyright 1997 by David Luhman