Retirement Investing

In this set of principles in the  Investment Advice: Retirement Planning series we'll be covering the rule of 72 and the powerful effect compounding can have on your investments. Also, things to look for in selecting the right stock mutual funds as well as the importance of diversifying your investments and understanding different mutual fund categories.

Principle #4: How The Rule of 72 Affects Your Financial Goals

This is the fourth principle in the Investment Advice: Retirement Planning For Everyone series.

To maximize your nest egg, it’s important to understand how compound interest and the rule of 72 affect your investments.

The rule of 72 is a mathematical formula that calculates approximately how long it takes your money to double, by dividing the interest rate you’re earning into the number 72. The answer is the number of years it takes for your money to double.

For instance, if you were able to earn an average 6 percent average annual rate of return on an investment, divide 72 by 6 and you would get 12. This is the number of years it would take for your money to double. That means that in 36 years, your money would double three times. First, $1,000 doubles to $2,000, then $2,000 doubles to $4,000 and finally $4,000 doubles to $8,000.

If you think that’s a lot, imagine if I could make 12 percent for those 36 years. This means the money would now double every 6 years (72 divided by 12). If you work through the numbers you will see that the total in 36 years is now $64,000, instead of $8,000. Wow! Doubling the interest in this example would mean making eight times the money. If you have some time on your hands, you could work through the example using 18 percent return. (The money would double every 4 years.) Just make sure to be sitting down when you do.

As you can see, the difference of a few percentage points over a lifetime can result in thousands of dollars of additional money for your retirement savings.

Lastly, here’s one of my favorite examples of compounding. Let’s say you’ve been hired to complete a task for someone that will take 30 days. He tells you to choose which way you would like to be paid for your month’s work. You can choose to receive either $1 million in a lump sum or one-cent on day one and have it doubled every day for 30 days. Which would you choose?

Well, since I’m writing about compounding, you probably guessed that one-cent doubled daily is the correct answer. By the way, that works out to over $5,300,000. The bottom line to all of this is, know the rates of return that your investments are earning and fight for every percentage point.

Principle #5: Selecting The Right Stock Mutual Funds

This is the fifth principle in the Investment Advice: Retirement Planning For Everyone series.

I believe mutual funds are one of the best investment vehicles and therefore should be a part in virtually every retirement plan. With mutual funds, you get the benefit of professional management. Some of the best minds on Wall Street handle the difficult job of selecting investments for the fund you’ve chosen while you’re at work or play.

You also get diversification. Many times 100 stocks or more are included in one fund. The main disadvantage to a mutual fund, of course, is that there is no guaranteed return. Stock mutual funds can increase or decrease in value due to fluctuations in the market, meaning you could either make money or lose it. Unlike a savings account or a CD with a major bank, there is no FDIC insurance to cover your losses.

However, for an investment to have a chance of out-pacing inflation, it can’t be tied to any particular fixed rate of return, like federally insured CDs and savings accounts. CDs and savings accounts play a role in retirement planning, but not as wealth-building vehicles.

It’s not my intention to give you all the information you might need regarding mutual fund investing, because there is more to that than I can cover in this post. But I can give you some simple guidelines for researching stock mutual funds. These tips will give you a jumping-off point to do your own research and to know which questions to ask if you use a financial advisor.

You will want to evaluate the track record, management team and categories of stocks within the fund. First, look at the fund’s previous track record, meaning how the fund has performed over the last one, three and five years. Sometimes a 10-year history is available, but many times that history isn’t helpful because so many variables could have changed over the years.

Keep in mind, even though past performance doesn’t guarantee future results, it will give you an idea whether the fund manager knows how to maximize returns. Whether he or she can do it again is another story, but at least you know whether the manager has traveled that road in the past. Also, when you check the track record of a particular fund, make sure that the fund manager who was responsible for those returns is still in charge. If not, you would have no way of evaluating the fund’s long-term management.

Next, evaluate the fees. There are a variety of charges associated with mutual funds. Commissions, marketing charges, and fees due upon sale, are just some the things you will want to research. Obviously, the more charges you pay, the more your return is reduced. Be sure to check the prospectus of each fund to see which charges apply.

Next, evaluate the risk factors. It’s also important to look at a fund’s risk category. Most fund families categorize their funds as low, medium or high risk.

Again, this information is really just scratching the surface of what you need to know to make an intelligent decision. So, don’t invest without first doing your homework and get your investment advice from a qualified financial advisor. Lastly, never invest in anything you don’t fully understand. Being in a hurry to invest can get you into trouble.

Principle #6:The Importance of Diversifying Your Investments and Understanding Different Mutual Fund Categories

This is the sixth principle in the Investment Advice: Retirement Planning For Everyone series.

I’ve heard people say, “Have all your eggs in one basket, and then watch that basket.” I disagree. I believe you should never have all your eggs in one basket, no matter how promising a particular investment might look. You should have a mix of stock funds, bond funds and cash savings in accordance with your investment objectives and retirement plan. The mix should be decided based on your age and risk tolerance and this type of investment advice should come from a qualified financial advisor.

As an example, normally, the younger you are, the more you would want your investment monies in stock funds, which have the potential to give you a higher return in exchange for higher risk. Over the long haul, the “up” years should make up for any “down” years that your investments have to weather in the stock market. This means that less of your investment dollars would go into bond funds and cash investments.

As you get older, preserving capital becomes an even greater consideration. Some of your nest egg should stay in stock funds to help hedge against inflation, but more of it should go into bond funds and cash investments. Do extensive personal research, seek professional help, or both to get a plan that suits your individual needs.

Above all else, keep in mind that preservation of principal should be your number one concern, because it’s easier to lose money than it is to earn it. I know this must seem like an obvious statement, but here’s a little example to prove it: If you invested $1,000 and in year one it earned a 50 percent return and the next year it lost 50 percent, did you make money, lose money or break even? Let’s do the math. A thousand dollars making a 50 percent annual return would total $1,500. If it then loses 50 percent, it would now total $750. So the answer is, you lost money. To maximize your nest egg, keep a close watch on risk and the preservation of your principal.

Proper mutual fund diversification can be a great tool to help you do that. It can help you balance risk and preserve your capital so you can retire in style.

Following is a rough outline of the different categories of mutual funds and the approximate risk inherent with each. There are thousands of mutual funds with almost countless sub-categories. But to keep it simple, I’ll discuss just some of the main categories. I’m going to start with the higher risk categories and work my way down to lower risk options.

• Aggressive growth stock mutual funds The highest risk is experienced with aggressive growth funds. These funds attempt to achieve the highest capital gains in exchange for high risk. Investments held in these funds are in companies that demonstrate high growth potential, usually with a lot of share-price volatility.
• Growth stock mutual funds Next are growth funds, which are designed to provide capital appreciation by investing in stocks with growth potential. Their goal is to provide gains over the long term, usually with less risk than their aggressive fund counterparts.
• Growth and income funds Next in line are growth and income funds. They are designed to pursue long-term growth, as well as provide regular dividend income. These funds invest mainly in stocks with a history of capital appreciation and consistent dividend payments.
• Balanced funds Following growth and income funds are balanced funds. They usually invest in stocks and bonds in an effort to obtain the highest return, consistent with a lower risk strategy. The relative balance of these securities can be changed to take advantage of phases in economic cycles.
• Bond funds Next are bond funds. Up to this point, all the funds I’ve discussed held some or all of their investments in stocks. As the name suggests, bond funds hold only bonds. There are all types of bond funds, from high to low risk, and from short to long-term.
• Money market funds Last on the risk scale, are money market funds. These funds invest only in cash or cash equivalents. They aren’t guaranteed but have a very solid track record for safety. The reason people invest here rather than in a savings account, is that money market funds not only usually pay more interest than regular savings accounts, but as interest rates rise in the general market, money market returns also rise.

As always, you’re going to want to do your homework and consult a qualified financial advisor before making any financial investment.

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Disclaimer 

In an attempt to provide the reader with accurate information, material has been obtained from sources believed to be reliable; however, the accuracy and completeness, and the opinions based thereon, are not, cannot and will not be guaranteed.

All examples in this text are hypothetical. Any negative statements or criticisms of individuals or organizations is unintentional. The information contained in this text represents the opinion of the author and is to be accepted as opinion only. It is not intended to provide legal, accounting or financial advice for individual readers.

Each individual's financial needs are different. This text is not meant to be utilized as a substitute for a sound financial plan. An individual financial plan should be developed only after consultation with a qualified professional.