The 12 Steps to Living Confidently: Horizon, Risk Tolerance, and Compounding
Investing for retirement may have a simple premise: make sure your savings are working hard, so when you stop working, you can live comfortably on your retirement income for many years to come. But the best way to do that differs for each person. Here are three factors to consider in creating your plan:
How long before you retire? Forty years? twenty years? Ten years? Your horizon is the amount of time before you begin drawing income from your retirement savings. It’s the prime period to build your retirement funds — and its length plays a role in determining how much risk you can afford to take.
Generally speaking, the more years you have before retirement, the greater the risk you may be willing to take with your money. If you’re nearing retirement, you may benefit from more conservative investments. This can help you plan more confidently.
Let’s consider Humpty Dumpty. A good egg, Humpty is 42 years old. He intends to retire at 65, so his time horizon is 23 years. Many financial specialists consider a horizon of more than 10 years to favor an aggressive investment portfolio — i.e., one designed to provide a higher rate of return while also involving a greater likelihood that those funds could lose value. The closer to retirement Humpty gets, the more his financial professional may advise him to scale back risk.
But Humpty’s horizon is not the only factor in his decision.
Just because you are decades away from retirement, that doesn’t automatically mean you should opt for higher-risk investments to chase a rate of return. You want to figure out your risk tolerance. What is your relationship with money? Are you comfortable riding an investment roller-coaster if you gain a favorable return down the road? Or do dips in market value give you high anxiety? The answers to these and other questions can help you determine whether you want an investment portfolio weighted toward stocks (aggressive) or fixed-income investments (low-risk) or a balance between the two.
To figure out how your emotions and behaviors impact the way you plan for retirement, take our retirement personality quiz. We’ve identified four distinct financial personalities. Are you a Seeker? A Connector? Or something else? Because you want to make rational, rather than emotional, investment decisions, it is helpful to be aware of your profile and to work with a financial professional to devise a plan that suits your level of risk tolerance. Learning how your personal style and financial habits intersect can help you plan more confidently.
The power of compounding
What Humpty may have sacrificed by starting later in life (age 42) and choosing a very low-risk investment strategy was the ability to fully exploit the incredible power of compounding. Compounding is the ability of investments to generate earnings. Here’s how it works, i.e., from age 20 to 30, Jack contributed $1,000 to his retirement account, earning seven percent compounded monthly. That $11,000 investment grew to $168,514 by age 65, when he retired from taking cows to market.1 Similarly, if he started saving at 55 years old, it would take him 15 times more savings per month to reach $1 million by age 65 than it would if he started at 25 years old.
By generating additional earnings, on top of accumulated earnings, compounding is a powerful tool to help you pursue retirement goals. The key is to begin saving as early as possible — though any time is good — and avoid withdrawing earnings from your account. Just let your retirement fund grow, year after year, and build a savings habit rather than chase a rate of return. Worth noting, while retirement accounts are tax-advantaged, your tax burden also compounds, and must be paid annually, if you are using a standard savings or investment account.
If you recall, Jack told his mother about the magic of compounding and, disbelieving, she threw his beans out the window. We advise a more prudent approach. Talking with a financial professional about your retirement goals and risk tolerance can help you develop a customized investment plan to help you live financially confident.
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2019-89108 Exp. 11/21