To get started, ask yourself these four basic questions:
- What are my investment goals?
- How long do I have to invest?
- How long do I expect to live in retirement?
- How much risk am I willing to take?
Your investment goals will depend on how you plan to spend your retirement. If you don't have a clear idea just yet, consider your current lifestyle and your dreams. This will help you formulate an investment goal, which you can adjust as retirement age approaches.
Next, determine how long it will be before you retire — your time horizon. Generally speaking, the longer your time horizon, the more risk you may be able to accept in exchange for potentially higher returns. If your time horizon is relatively short, you may not want to accept as much risk and may prefer a more stable investment.
Determine your risk tolerance
Can you accept a lot of fluctuation in the value of your investment for potentially higher returns? If so, you may want to consider stocks. However, if you feel anxious when the markets begin to fall, you may want to consider fixed-income investments. Or, choose a balanced approach that attempts to cover for a variety of market conditions.
Remember, taking the "safest" route with your money may not be safe at all. Perhaps the riskiest thing you could do is to not invest your money at all. That's because you expose your money to the risk of inflation, the insidious erosion of your money's purchasing power due to the rise in the prices of goods and services.
Funding your retirement
Traditional methods for funding retirement, such as Social Security and other retirement benefits, may not meet all your financial needs — especially when people are living longer and retiring at an earlier age.
An employer-sponsored, tax-deferred plan is one of the most powerful tools available today. Depending on the company and the options available, it enables you to decide whether to participate, how much money goes in, how it's invested, and how long it stays invested. You can select investments that match your financial objectives and reflect your comfort with risk.
Stick to your strategy
Whichever method you choose to fund your retirement, it's generally best to stick with your strategy—even if the markets go down. Unless your life situation changes, you will likely be better off sticking with your strategy than moving in and out of investments in pursuit of better returns.
This doesn't mean, however, that you should set your investment strategy in stone. You should regularly evaluate your investment decisions and adjust them accordingly as your needs change and your time horizon grows shorter.
The magic of compounding
Put time to work
When you invest in something that earns a rate of return, it takes advantage of compounding—the ability of an asset to generate earnings, which can be reinvested to generate more earnings. It is possible that the growth in your investment over time may be more due to compounded earnings than to how much money you contribute.
The key is to start early
Consider this hypothetical example of two investors who are the same age, earn the same salary and face the same choices about saving and spending.
Investor A starts saving at age 25 and contributes $200 per month to her tax-deferred retirement account. She continues contributing $200 per month for her working lifetime to age 65—a total of 41 years.
Investor B waits 10 years, until age 35, to start saving for retirement, figuring he can catch up by contributing more. He invests $400 per month (twice as much as Investor A) for 31 years until retirement at age 65.
If both investors earn 7% returns compounded monthly, the results are as follows:
|$200/month starting at age 25
|$400/month starting at age 35
|Total contributions at age 65
|Retirement fund value at 65 with 7% monthly compounding
This hypothetical example is for illustrative purposes only and is not intended to reflect the return of any actual investment. Investments do not typically grow at an even rate of return and may experience negative growth.
From this example you can see that investor B never catches up and the difference is substantial. In fact, many people faced with Investor B's situation have trouble catching up because a much larger chunk of a monthly contribution is required if saving and compounding have been delayed for 10 years.
How to achieve compound growth:
- Interest can accrue on interest
When returns from money market savings accounts or certificates of deposit are reinvested, these earnings can also produce interest.
- Cash dividends reinvested can purchase more stock
More shares of stock can increase your dividend payment.
- Interest income can be reinvested in principal
Growing the principal investment on a bond can produce additional earnings. This is allowed on certain bonds and the rules vary.
- An investment professional can answer questions
Understanding all of your investment options and the impact of compounding is important when planning for retirement.
Avoiding a savings shortfall
Keep yourself on track by following these preventative measures:
- Decide on a realistic amount to save. If your income varies or is seasonal, select an achievable amount for each month and try to save that amount.
- Try to follow your plan, save regularly, and increase your savings whenever you can. Think of your planned savings as a fixed obligation and set this money aside from disposable income. Practice careful shopping and resist impulse buying.
- Periodically review your progress toward your goals. Adjust the amount you save as old financial goals are met and new ones are set. If you receive a gift of money, an increase in salary, a tax refund, or other unexpected funds, consider applying as much of this money as possible to your savings goals.
- Try to build and maintain an emergency fund equal to three to six months of your salary.
- Try to save for your recurring expenses, such as taxes or insurance premiums. Estimate how much to set aside each month to meet those expenses. You might also consider saving money for annual vacations, household improvements, and holidays and gift giving as recurring expenses.
- Try to guard against borrowing money, or building credit card debt.