The three most important rules of investing sound oddly similar to the instructions I received from my more seasoned (read: older) family and friends before heading into my first job. While the work environment has changed dramatically over the last decade, and less of my friends than ever are working in a typical 8am to 5pm structured job, the principles still hold true.
- Get In Early
- Stay Late
- Focus on What You Can Control
Getting in early and staying late represent a fundamental truth that hard work is important in building a career. In fact, the only way to make hard work worthless is if you are working on the wrong things. Investing can be hard work too, and all three of these simple truths still apply. Today we’ll dissect each rule’s practical application.
1. Successful Investing Starts With Getting In Early
Most of you probably know the numbers and statistics, but the impact of time on compounding investment growth is fascinating. If you invest $500 a month during a 40-year career starting at age 25 with an assumed growth rate of 6.5%, you will have $1.14 million saved by age 65. By delaying that start date to age 35 (reducing time by 25%) you would have to more than double your investment (increase over 100%) just to catch up.
Column 4 in the above graph shows that starting early and doubling your investment amount every 10 years may lead to a more achievable best of both worlds. Often starting with $500 or $1,000 each month as a 25 year old may be difficult, but even starting small and increasing over time can be very effective.
Four Ways to Get Invested Early
- Plan ahead: You should always be investing for a purpose and aiming at a target. In order to set money aside you have to have an idea of what you can invest while still maintaining a sound budget.
- Automate your investment savings: Saving to a company retirement plan is a great example of this. It often seems like the money disappears and grows without any pain because it is coming out automatically and you are living on whatever is left. Making additional savings happen the same way can be a huge behavioral advantage in learning to live on less.
- Increase savings/investments when life changes: When life changes, financial changes are easier to make. Did you just pay off your car? What are you doing with that $300 a month now? Did you just move to a new city where the cost of living is cheaper? What is happening with the difference? Are you increasing your lifestyle or are you increasing your investment account? Whether it is a raise, an expense reduction, a debt payoff, or an inheritance, having a plan for what will happen when life changes is essential to success. My goal for life changes is always to save 75% give 10% away, and reward myself (or my wife) with the remaining 15%.
- Start small and increase over time: I started small, investing a few thousand dollars a year in a Roth IRA, and over time it started growing. As my career began to develop I started taking advantage of other investment vehicles, and increasing the dollar amount. Now my wife and I save more in one month than what I once saved in an entire year, and the most important part was starting! When you start working on what’s important, you get in the habit of making “important” a priority.
Start Today: What steps can you take today to start saving for tomorrow?
2. Why You Shouldn’t Leave the Investment Game at Retirement
So you started well and invested early, but just because you are able to retire doesn’t mean you have arrived, and can turn off all the risk. The real goal for retirement is not to have a large dollar number in your investment account, but to produce a sustainable stream of resources that provides for your needs. The primary reason you need to stay invested late into retirement is to reduce the impact of inflation on your funds. With inflation increasing your expenses at 3% (on average) each year, though recently it has been slightly lower, your costs will change dramatically over a 10 year or 20 year period.
Naturally our minds create finish lines to keep us encouraged and focused on progress. In fact, there is some legitimate psychological effect that allows the brain and the body to accomplish more, knowing that the finish line is near. When there is an undefined finish line our minds get tired, and it requires additional patience and focus to achieve predictable outcomes.
The challenge with investing is that you must continue to stay engaged late into your retirement years. The finish line is often undefined because the money has to last until you die, and no one knows when that is! This is what makes people fearful. To make the challenge more difficult, companies that once took on this risk for their loyal employees through pension plans have now transferred the risk back to the employee requiring them to endure the market ups and downs, and make investment decisions in their own 401k and retirement plans.
3 Ways to Stay Invested Late
- Define “Enough” for your family: Don’t stop working to determine how much is enough for you. The single biggest retirement killer is spending. If you can keep your expenses low the amount you need to save and invest decreases dramatically, and your ability to stay invested will increase. The stress level of the high spender in retirement is always high no matter the amount of money he or she has, but those who set modest limits for their spending find extreme comfort when the unexpected happens.
As a general rule you can withdraw 4% from a balanced (mix of stocks and bonds) investment account annually, with an inflation adjustment to your withdrawal each year, and your money will last at least 30 years in retirement (historically this has held true).
Example: If you are retiring this year, and can keep your budgeted expenses to $55,000 per year, with a social security benefit of $24,000, you will likely need about $1,000,000 to retire (assuming $7,750 in tax and a total withdrawal $40k from a tax deferred account). The higher your spending, the larger the number you need to save, as each dollar of annual spending requires an additional $25 of savings plus an additional tax adjustment. To spend $75,000 with the same social security would require $1,600,000 (assuming $13,000 in tax and a total annual withdrawal of $64,000).
- Evaluate everything in terms of risk (how much downside can I afford and how long can I weather a storm): Personally, I think breaking your investments down into risk buckets is a great way to manage your investment risk. You need to have some cash on hand in retirement, generally at least one year of expenses. You should also have 5-7 years of (non-pension/annuity) need invested more conservatively. This type of investing would allow you to weather a significant downturn, and prevent you from having to tap into your more aggressive investments for several years. It also insulates you from fear in a market correction allowing you to stay invested and protecting you from a fear based withdrawal when the market is selling off.
- Consider alternate income sources: Some people think investing only includes stocks and bonds, but true diversification may need to include other assets as well. Providing for a future is about replacing income, and many successful retirees have created their own income streams through multiple investment vehicles. Real estate investments and rental income are a great example of generating income from an asset. This can be a dangerous game for a novice, and requires both cash flow and liquidity in order to create a safe environment for investing. Proper planning for vacancy rates, and ability to float periods of vacancy are imperative, but returns and income stability can often provide some balance and consistency to a typical investment portfolio.
Start Today: What is your plan to create income for your retirement? Plan now to determine how much is enough, and what it will take to get there!
3. Stay Focused on What You Can Do, Don’t Worry About the Rest
The best way to ruin a good investment plan is spending your energy on the wrong things. Spending time on the right things and doing the right research will have a significant impact on your ability to meet your investment goals long term.
What you can’t control:
- The past: Each one of us could have done something different, planned more carefully, started earlier, avoided investing in Enron, not purchased that sports car right out of college (I made that mistake), or not used a credit card to get started in life. You can’t take back what has already happened, but you can minimize the damage if you plan to take control now. Don’t spend your energy on things you can’t change.
- The market’s ups and downs: Whether the price of oil declines and sends foreign markets into a tailspin, the US growth figures increase or decrease during a year, or the new congress makes the market go up or down is not in your control. Every story has two sides, and most of the time the smartest people in the world disagree. It is important to have a few trusted voices that you listen to regarding how to build a portfolio, but having diversity in your investments, and allowing time to work for you are the two best ways to minimize the volatility. You can’t control how the markets will react to every piece of news.
- The days you have left: No one knows their exact life span. Most of us are hoping we get to stick around a while, and want enough money to last us until that point. We cannot determine when we will die, but we can plan and prepare as if we might live our current lifestyle beyond our current life expectancy. When I am planning for people I usually use age 90 or 95 as a benchmark, just to ensure they don’t outlive their funds. If your parents or grandparents lived to be 102, you might want to add a few extra years to that figure. You can plan for what you don’t know, but you need good advice, a plan you trust, and the proactive approach that allows you to follow that plan.
What you can control (You can control a lot!)
- Wealth enhancement: You can control your goals, your spending, your investment decisions, your approach to taxes, the ownership structure of your business, the fees you pay for each of the services you have hired someone to take care of for you, and the amount of time you spend on each, among many other things. If you are shorter on time, but longer on money, it might be best to hire somebody to help you keep tabs on everything. If you have the opposite problem, you will need to have a plan yourself, and use as many tools as you can to create efficiencies.
- Wealth transfer: One of the most common mistakes I find in financial plans is that nothing is planned for when you die. You have just accomplished a great feat by having assets left at your passing, but you have no instructions for how they should be distributed to your heirs, gifted to charity, or otherwise used for any purpose you choose. Using an estate attorney is typically recommended, but if you are short on cash, there are even online options that can at least help you get a good start.
- Wealth protection: What are the biggest risks to your plan? Do you need to transfer those risks by purchasing insurance, mitigate those risks by having a plan in place to avoid them, or avoid those risks, by stopping some activity? When I think of large risks, I think about loss of income, loss of life, health concerns and other major calamities that could occur. There are many types of insurance to protect you, but it always costs money to transfer risk. Long term care insurance, life insurance, disability insurance, etc. are all designed to help with these concerns. If your risk of death is increased by the fact that you drive racecars for a living, you may want to increase the protection you have for you family by having a large policy in place (risk transfer), or finding a new career (risk avoidance).
- A life of generosity: There are many people I know that were not rich, but lived richly. I am sure you have met these people. They are usually the everyday savers that somehow scrap up enough money to take you to dinner, spend their time doing what they feel is important and giving generously to the causes and individuals they love. Learning to live a simple life in order to align your resources and your priorities can often be the most rewarding decision you will make. Though giving may not increase the size of your balance sheet, it may allow you to live more fully, and increase the wealth and impact of the life you live.
Start Today: Are you focusing your energy on things you can control? Take one step today to change your focus.
Learning to invest successfully can seem like a daunting goal, however, by following the basic and concrete steps above, you will be able to meet – and potentially exceed – your retirement goals.