Whether retirement is on the near horizon or still a distant goal, it’s never too early to start financially preparing for this stage in your life. In the first part of my “What to Expect When You’re Expecting Retirement” series, I discussed the why, how, and challenges associated with building a retirement nest egg. To further develop a healthy nest egg that supports you in your future endeavors, it is important to learn how to build a customized portfolio.
For many, building a portfolio means investing in the stock and bond markets, which can sometimes cause people to hesitate. Fear not! Investing may be a less dangerous game if you follow four simple rules.
1. Establish an Emergency Fund
Before you start a portfolio for your long-term nest egg, it is essential that you establish an emergency fund for short-term problems, such as an unexpected car or home repair, or in an extreme instance, a temporary disability. This will help you keep your nest-egg portfolio separate and protected from life’s unexpected costs. To ensure a comfortable emergency fund, set aside six months of living expenses. For example, if your fixed expenses are $2,000 a month, then keep $12,000 in your emergency fund. This amount can be modified if you have a line of credit with your bank account. Lines of credit are not automatic, but if you have a credit score of 700 or better, consider asking your banker for a line of credit on your checking account. In full disclosure, account minimums may be required, but this line of credit will help you avoid leaving money in cash that is generating less than 1 percent interest (one of the lowest savings rates in the past 50 years).
Once you have established an emergency fund or a line of credit that can be available to you in times of need, it's time to approach the brave world of stock and bond investing.
2. Focus on Asset Allocation
While many people and experts spend a lot of time trying to determine which stock or bond to purchase, a study published by the Financial Analysts Journal suggests that asset allocation is far more important than whether you buy Yum! brand or Coca-Cola. Looking at the determinants of portfolio performance, the study found that the mix of stock, bond, and cash in a portfolio explained, on average, 93.6 percent of the variation in total return of a portfolio. Therefore, being invested for the long term in a diversified portfolio of stocks, bonds, and perhaps an index fund is more important than agonizing over which specific stock to own.
3. Have a Long-Term Investment Horizon
Investing in the stock market is a long-term game. According to data from the Ibbotson Yearbook going back to 1926, if you invested in Standard & Poor’s 500 index and pulled that money out within the same year, your chances of making money were only 50 percent — no better than the flip of a coin. However, should you have committed funds to the stock market for five years or more, your chances of making money grew to 87 percent. Given a time horizon of 10 years or more, an S&P 500 investor had close to a 95 percent chance of making money. While past performance is no guarantee of future results, time — not timing — has shown to be a crucial element in successful investing needed to grow your nest egg. The caveat to building a portfolio where assets are invested in the stock market is that it’s not for the faint of heart!
4. Don’t Let Your EQ Trump Your IQ
Investing has a strong emotional component, but it’s important to support your decisions with sound financial reasoning. The emotional quotient (EQ) is that “fight or flight” instinct that doesn’t necessarily lead to the best decision. For example, it might lead you to panic and sell at precisely the wrong time.
Corrections in the stock market are not a question of if, but when. In fact, history shows that bear markets have occurred approximately every five years. Further, these downturns can average 30 percent or more. Staying the course even when it's tough is key. Sounds obvious, right? Not at all.
Dalbar, an institution that looks at the performance of an investment class versus actual investor performance, has found marked differences between investment and investor returns. A J.P. Morgan study amplifies the point by showing that in 20 years of recent annualized returns, the S&P 500 returned 9.2 percent, while the average investor earned only 2.5 percent during the same period. It’s a rather apt illustration of two of the major drivers of human investment behavior: fear and greed! Fear causes many to avoid investing when the stock market is low and greed causes others to jump in at the top because they don’t want to miss out on all the gains.
Ironically, when a retail store has a 50 percent off sale on merchandise, we’re often the first to run down and take advantage of the bonanza. However, when the stock market declines, investors often recoil rather than buying good stocks cheaply. Industry data looking at stock market influxes showed that in 1999, at the height of the dot-com boom, more money flowed into the market than had in a decade. Conversely, selling was highest in 2008, at the bottom of the market. The problem with going with the flow is that investors may end up buying high and selling low based on emotion, rather than rational investing.
In investing, sometimes the hardest thing to do is the best thing to do. Having an advisor or a coach may help you balance your IQ and EQ.
Stay tuned for our next series as we discuss the S&P 500, the most widely followed index among investors. We will outline the various sectors within the S&P index, along with the bond market and alternative investments.
Securities offered through FSC Securities Corporation, member FINRA/SIPC. Advisory and insurance services offered through Stavis & Cohen Financial, a registered investment advisor not affiliated with FSC Securities Corporation.
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Investing involves risk including the potential loss of principal. No investment strategy, including diversification, asset allocation and rebalancing, can guarantee a profit or protect against loss. Indexes are unmanaged and cannot be invested in directly.
Although this information has been gathered from sources believed to be reliable, it cannot be guaranteed and the accuracy of the information should be independently verified.
Deborah Stavis is a member of the DailyWorth Connect Program. Read more about the program here.