If you are planning for retirement, you are probably interested in learning how to invest. The way that you invest and save before retirement will impact the rest of your life. It’s also worth noting that the strategy that works when you are in your 20s and 30s will likely not work once you have reached retirement.
Before you learn how to invest, you will want to understand asset allocation. There are many classes of assets, or investment categories. The three main categories are:
- Cash and equivalents
- Stocks or equities
- Bonds or fixed-income securities
Other classes can include real estate and commodities. Each of these categories has different levels of risks and returns; this means that, over time, each category behaves differently. Factors such as the economy play a role in this.
For example, in a good economy, investors are confident that they can gain potentially higher returns and are more likely to add to their investments or leave their portfolios as they are. However, when the economy is not doing as well, many investors take their money out of stocks and instead put it in bonds. Stocks and bonds have a negative correlation, which means that when the returns on one of them go up, the other’s will sink. This is important because putting all of your money in one category is a huge risk. If that category’s value declines, you do not have your money anywhere else, exposing your full investment to that volatility. As a way of hedging this all-or-nothing exposure, it is good idea to diversify your portfolio by investing your money in a variety of categories. If one of the assets does not do well, your other asset classes are likely to offset that which is performing poorly.
Arranging your assets is also known as asset allocation. This will look different for you at different stages of life, and your proximity to retirement will also play a role.
Planning for Retirement in Your 20s
In your 20s, one way to allocate your assets is by placing 80 to 90 percent in stocks. The other 10 to 20 percent can go into bonds.
In your 20s, you may have recently graduated college and be paying off your debts; however, this is still a good time for you to begin investing. Whether through an IRA or your company’s 401(k), you should invest as much as you can.
Even if it is just a small amount, you have the advantage of time. Everything you invest in your 20s has a bigger growth potential because of compounding (the earnings on your interest and growth). You can absorb market changes because you have more time, allowing you to avoid investments with a slower earning potential.
Focused on Your Career in Your 30s
Now is the time to start investing if you have not already done so. You still have enough time to get the rewards from compound interest, but you are still young enough to invest about 10 to 15 percent of your income. In your 30s, you can allocate your assets by placing 70 to 80 percent in stocks and the remaining 20 to 30 percent in bonds.
You should contribute to retirement even if you are starting a family or paying a mortgage. There are still 30 to 40 years left for you to work, so you will want to maximize your contributions. You should match your company’s 401(k) and even consider maxing it out, provided that you are within the IRS’ maximum contribution limits. It is a good idea to start adding some bonds now.
Thinking About Retirement in Your 40s
Once you have reached your 40s, you can place about 60 to 70 percent of your savings in stocks and 30 to 40 percent in bonds.
This is the time to seriously start strategizing for retirement. If you are on track, you can build your portfolio because you are at the middle of your career. You are most likely nearing your highest earning potential, and every financial decision should consider your retirement savings. If you do not know which funds you should choose, meet with a financial advisor.
Nearing Retirement in Your 50s and 60s
You should not lose focus when you are in your 50s and 60s. You can choose an asset allocation of 50 to 60 percent in stocks and 40 to 50 percent in bonds. Additionally, you should switch some investments to more stable funds so you do not have all your money at risk.
If you are at least 50 years of age, you’ll be likely to make “catch-up” contributions, which allow you to contribute an additional amount beyond the standard IRS contribution limits. This year, you can place as much as $26,000 in your 401(k) or up to $7,000 in your IRA.
Retirement in Your 70s and 80s
Once you are in your 70s or 80s, you will only want to have about 30 to 50 percent in stocks, with the remainder in bonds. Once you are retired, you should focus more on income. You will want to choose stocks that have dividend income so you can add it to your bond holdings.
The best time to start investing is at a very young age. The power of compounding over time is incredible, and the sooner you save the better. I used a popular retirement planning application called WealthTrace to look at what happens if a person saves $10,000 a year starting at age 25 vs. age 35. The amount they have at retirement at age 65 shows a difference of over $300,000!
It’s never too late to start if you haven’t already done so. As long as your decisions are right for your age, your investments will be able to age with you. Meeting with a financial professional or using do-it-yourself, accurate retirement planning software will help you see where you stand and help you make the right decisions.