Focus on the Basics
How do you choose the right combination of investments to help you work towards a goal that may be decades away? The answer is to focus on the basics. Make sure you are getting these fundamentals right:
Don’t wait — invest now. To put the power of compounding to work for you, start investing now. It’s easy to put off investing, thinking you’ll have more money or more time at some point in the future. Typically, however, you’ll be better off saving less now than waiting and saving more later. Consider the savings habits of a 20-year-old couple. The wife starts contributing $2,000 per year to a tax-deferred investment, such as a 401(k) plan, when she is 20. After 10 years, she decides to stop investing and let her money grow until retirement. She has invested a total of $20,000. Her husband starts investing when she stops, investing $2,000 per year from the time he is 30 until he retires at age 65. Thus, he saves every year for 35 years, making a total contribution of $70,000 — $50,000 more than his wife. If they both earn 8% compounded annually, who will have the larger potential balance at age 65? Time and compounding of earnings favor the wife. Before paying any taxes, her balance would equal $462,649, while her husband’s balance would be $372,204. (This example is provided for illustrative purposes only and is not intended to project the performance of a specific investment.)
Live below your means so you can invest more. It’s a basic fact that most people have trouble coming to grips with — the amount of money you have left over for investing is a direct result of your lifestyle. Don’t have any money left over for investing? Ruthlessly cut your living expenses. Redirect all those reductions to investments. This should help significantly with your retirement. First, you’ll be saving significant sums for that goal. Second, you’ll be living on significantly less than you’re earning, so you’ll need less for retirement.
Maintain reasonable return expectations. When developing your financial goals, you’ll typically decide how much you need, when you’ll need the money, and how much you’ll earn on those savings. Those factors will determine how much you need to save on an annual basis to reach your goals. The higher your expected return on your investments, the less you need to save every year. However, if your assumed rate of return is significantly higher than your actual rate of return, you won’t reach your goals. Thus, it’s important to come up with reasonable return expectations. While past returns aren’t a guarantee of future returns, you’ll want to start by reviewing historical rates of return for investments you’re interested in. You can then adjust those returns based on your expectations for the future. Assessing your progress every year will allow you to make adjustments along the way.
Understand that risk can’t be totally avoided. All investments are subject to different types of risk, which can affect the investment’s return. Cash is primarily affected by purchasing-power risk, or the risk that its purchasing power will decrease due to inflation. Bonds are subject to interest-rate risk, or the risk that interest rates will rise and cause the bond’s value to decrease, and default risk, or the risk that the issuer will not repay the bond. Stocks are primarily subject to nommarket risk, or the risk that events specific to a company or its industry will adversely affect a stock’s price, and market risk, or the risk that a stock will be affected by overall stock market movements. These risks make some investments more suitable for longer investment periods and others more suitable for shorter investment periods.
Diversify your portfolio. When stocks had above-average returns for an extended period, diversification acted as a drag on total return. By definition, allocating anything other than all of your portfolio to the best-performing asset lowers your return. But when stocks declined substantially, the disadvantage of investing only in one asset class became apparent. Typically, you do not know which asset class will perform best on a year-to-year basis. Diversification is a defensive strategy — it helps protect your portfolio during market downturns and helps reduce your portfolio’s volatility. Diversify your investment portfolio among a variety of investment categories, such as stocks, bonds, cash, real estate, and other alternatives. Also diversify within investment categories.
Only invest in the stock market for the long term.Stocks should only be considered by investors with an investment timeframe of at least five years. Remaining in the market over the long term reduces the risk of receiving a lower return than you expected.
Don’t try to time the market. Timing the market is a difficult strategy to accomplish successfully, since so many factors affect the market. Remember that most people, including professionals, having difficulty timing the market with any degree of accuracy. Significant market gains can occur in a matter of days, making it risky to be out of the market for any length of time. Instead of timing the market, concentrate on setting an investment program that works in all market environments and that you can stick with in good and bad times.
Pay attention to taxes. Taxes are probably your portfolio’s largest expense. Using strategies that defer income for as long as possible can make a substantial difference in the ultimate size of your portfolio. Some strategies to consider include utilizing tax-deferred investment vehicles (such as 401(k) plans and individual retirement accounts), minimizing portfolio turnover, selling investments with losses to offset gains, and placing assets generating ordinary income or that you want to trade frequently in your tax-deferred accounts.
Using diversification as part of your investment strategy neither assures nor guarantees better performance and cannot protect against loss in declining markets.
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This newsletter was prepared by Integrated Concepts Group, Inc. The opinions expressed in this newsletter are for general information only and are not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. The views expressed are those of the author and may not necessarily reflect those held by PlanMember Securities Corporation. Material presented is believed to be from a reliable sources and PSEC makes no representation as to it accuracy or completeness.