Building a retirement portfolio is a daunting task, one made more complex by the finance industry’s liberal use of confusing investing terms that don’t matter much anyway. You shouldn’t have to interpret concepts such as standard deviation or understand a Monte Carlo analysis. Comprehending things like correlation coefficient, alpha, and beta are irrelevant to reaching your financial goals, but Wall Street wants you to think otherwise.
Compiling a retirement portfolio is all about dividing your investments up in the various asset classes of stocks, bonds, REITS (real estate investment trusts), and cash-type investments in a way that reflects your need and ability to take risk.
Speaking of risk, how do you define investing risk? Instead of struggling to decipher Wall Street’s nonsensical lingo, try this interpretation of risk instead:
Investment risk is the risk that the money you are counting on to purchase something important or sustain your lifestyle at some point in the future won’t be there when you need it.
Let’s take a look at the different types of risk in your portfolio, based on the above characterization. Say you are a 25-year-old investor, recently graduated from college and beginning to sock away money in your company-sponsored retirement plan. The risk you face isn’t a steep stock market decline; rather, it is how inflation will affect your purchasing power over the next 40 years of saving and investing. For all of you 25-year-old investors — 35- and 45-year-old investors, too — a stock market sell-off is clearly in your best interest, as your future monthly contributions will allow you to purchase stocks at much lower prices, generating higher returns down the road.
So the next time the Dow index plummets 500 points in a day, or 2,000 points over the course of two years, it should serve as a cause for celebration in your accumulation of long-term wealth.
Let’s look at the other end of the age spectrum. If you are a 65-year-old investor and getting ready to retire, the allocation of assets between stocks and bonds becomes far more critical, not only to continue your portfolio’s growth for the next 35 years, but also to preserve what you already have accumulated.
At this point in your life, a smart financial plan is invaluable in determining your asset allocation. Here, the goal is to have enough money invested in conservative, fixed-income investments (bonds, bond funds, CDs, etc.) that you can liquidate these investments and, combined with Social Security and pensions, generate income needed to cover your monthly expenses. In other words, you never want to be in a position that you have to sell your stocks in a bear market to pay the electrical bill.
There are many factors in creating an asset allocation that is right for you. A good way to begin the process is to subtract 10 from your age, and make that your bond allocation percentage. For instance, as a 55-year-old investor, my bond allocation would be 45 percent, and 55 percent would be in stocks. However, two factors in my life suggest an even more aggressive portfolio. Because of my intent to work at least another 15 years (hey, I love my job!) and the low rates on bonds, I have set my allocation at a 65-35 stock-to-bond ratio.
My portfolio allocation is set almost on autopilot. This allows me to fully embrace all the risks and rewards that I encounter in my daily life while ignoring the daily stock market swings. It is what I’m all about.