Investing For Your Retirement
|This paper is written and provided by SHARP INVESTMENTS, a Registered Investment Advisor. SHARP INVESTMENTS manages money for individuals and businesses, specializing in small business pension plan management. SHARP INVESTMENTS is a licensed and bonded investment company. For a free consultation on the advantages of money management, contact Daniel R. Sharp at 503-520-5000.|
Most of us, whether self employed or employees, will stop actively producing income through our work at some
point in our lives. All of us wish to sustain the lifestyle to which we have become accustomed once we are ready
to stop working for a living. In today's world, traditional sources of retirement income, like social security,
are no longer the guarantee that they were for our parents and grandparents. Social Security, which was never intended
to be the sole source of retirement income, may not be available at the time you retire. Even if social security
is available, the monthly payment will likely be grossly inadequate.
In days past, employees enjoying long relationships with their employers were rewarded with generous pension checks. In today's world, it is becoming increasingly rare for an employee to work 40 years, 30 years, or even 10 years for the same employer. As a result, for many of us a pension check from a past employer will not be a significant source of retirement income.
For the self-employed, the source of retirement income generally narrows down to either not retiring, or retiring and selling their business for retirement funds. This raises many problems for family businesses. Take a farm, for example, where the parents may wish to pass the business on to the children. Without other retirement income, they are not able to sustain their lifestyle without selling off assets that the children may need for the business. Even when the small business owner is eager to sell that which they have spent their lifetimes building up, Federal and State taxes take a tremendous bite out of the proceeds, leaving a limited amount of funds for retirement.
Most people have begun to sense that they may not be able to count on the same sources of retirement income that previous generations have. People are striving to set aside money, earmarked for retirement, as a regular savings plan. This is a difficult task for most households, which in many cases are just trying to make ends meet. Unfortunately, for every dollar set aside in a savings plan, about forty cents goes to pay various taxes. Any after-tax money that manages to be saved and invested is then subject to annual taxes on the interest or income. Saving and investing for retirement with after-tax money is like climbing a mountain taking a step back for every two steps forward.
If Social Security, fat pension checks, savings, or selling your business won't provide for your retirement, what will? What are YOU going to do? Hope you don't get old? Hope you'll win the lottery? The odds of either happening are about the same: ZERO.
Fortunately, there is a clear solution to the problem, but it requires you to plan ahead for retirement. It
is known as a Qualified Retirement Plan, and is available to individuals, employees, employers, and
the self-employed. The government has set up certain conditions which, when met, allow people and businesses to
provide for a comfortable retirement without the disadvantages of the methods previously discussed.
Qualified Retirement Plans allow you to;
1. Save money towards your retirement, tax free
2. Lower your current taxes, business and personal
3. Maintain control over your retirement funds
4. Provide a safe, significant source of retirement income that can never be taken away from you
This is why a Qualified Retirement Plan is such a clear favorite for creating a comfortable retirement income.
Picture two snowballs at the top of a hill. One snowball is twice as large as the other. The larger snowball represents the money put into a Qualified Retirement Plan, from which no taxes are subtracted. The smaller snowball represents what is left of the money put into a savings or investment account after almost half of it is removed for taxes. Picture the two snowballs rolling down the hill. The larger snowball quickly picks up steam and size, and soon becomes a mammoth object, unstoppable in it's growth and speed. However, the smaller snowball is stopped every ten feet down
the hill and cut in half, representing the annual taxes due on investment income, dividends and capital gains. Every time it gets up to speed, it is stopped, reduced in size and then has to regain speed only to be stopped and reduced again and again.
Is it any wonder then, that at the bottom of the hill the larger snowball, only twice as large at the top of the hill, can now easily be ten, fifty, or a hundred times larger than the little snowball? Which snowball do you want?
Whether you are an employer, employee, or self-employed, whether you work for a large or small company, or are
just an individual with an IRA, there are certain basics you need to understand about what is happening with your
There has been a trend in the last ten years of employers shifting the responsibility and liability of retirement funds from themselves to their employees. There are two reasons for this:
1. Employers are relieved of investment responsibility and liability, and investment choices are left to the employee. Retirement plans that do this are known as Defined Contribution Plans. Examples include: 401k's, Profit Sharing Plans, Individual Retirement Arrangements (IRA's), Keogh's and Simplified Employee Pension (SEP) plans.
2. Employers can downsize their traditional pension plan (known as Defined Benefit Plans), thus cutting costs and making themselves less attractive to corporate raiders or a hostile takeover.
As a result, the burden of investing is rapidly shifting away from the institution and towards the individual. This is a complicated area in which people generally don't feel skilled or experienced, but still must make certain investment decisions.
Consider how important your retirement funds will be to you in the future. You are now in the driver's seat with regard to your investment choices, goals, and strategy. It can be a sobering thought. Ignoring the issue is the easy way out, but eventually the price must be paid come judgment day (the day you want to retire). You must be prepared and the best way is to start today.
There are really only two essential actions that MUST be contemplated by people trying to understand their retirement plans:
1. When to start in order to meet your retirement goals. This often comes too late for those of you close to retirement with no plan. For the rest of us this is THE most important thing to consider. If one starts saving for retirement early enough, everything else they do is minor in comparison. Good or bad strategies, good or bad investment decisions, all become secondary IF a person starts early enough. Of course, retirement is the last thing on the mind of a 25-year old, or even a 45-year old.
2. Contribute as much as you can as soon as you can. It is better to contribute heavily to your retirement fund for a short period and then completely stop, than to contribute small amounts for long periods of time. It is better to make a true sacrifice for a couple of years than to contribute a token amount for many many years. Also, realize that every dollar you place in a retirement account is actually only costing you sixty cents. Most people, especially young people, see no reason to give up any of their monthly salary for any reason, even retirement. However, it becomes much easier to do when you realize that the government gets forty cents of every dollar you don't put into a retirement account. You instantly make 40% on your investment, a profit margin most businesses would kill for. Every year most of us do whatever it takes to write that check to the IRS, where the only return we may see is the occasional slice of government cheese. Why not write that check to your own retirement instead?
Bob has $239,000 upon retirement
Jim has $ 82,000 upon retirement
Many employees and employers choose very conservative investments for their pension funds because they feel
they shouldn't put their retirement funds at risk. They are equating risk with safety. These are two completely
Risk in investing is defined as the amount of uncertainty in the return of an investment.
Safety in investing is defined as the amount of certainty in reaching an investment goal.
The above chart shows the results of two investment strategies, A and B. A is a low risk
investment, meaning the asset growth from year to year is very predictable. B is a very risky investment,
meaning that the asset growth from one year to the next is very unpredictable, and there are losses some years.
However, since the investment goal is a million dollars, A is an unsafe investment because it has no chance
of reaching the goal. B is a safer investment in that there are much better odds of it reaching the investment
Therefore, a risky investment can either be safe or unsafe, dependent on the potential of reaching the investor's goal. Likewise, a no-risk investment can be very unsafe because it may have virtually no chance of attaining the investor's goal.
Look at your own retirement fund right now. If you retired this very minute, would this fund be enough to support you? For most of us, the answer is no. But a no-risk investment in your retirement fund will not increase your purchasing power, it will simply keep pace with inflation and you'll have no more real money than you have today. Without risk, there is no real return. Pension funds that don't take on some risk, don't grow. Pension funds that don't grow, don't provide for your retirement.
Fred will have about $200,000, and will be nowhere near his investment goals
Laura should have about $900,000, easily meeting her investment goals
Who has made the safest investment?
It may not be very risky for someone to keep their retirement funds in a money market for 30 years, but it would be very unsafe because there would be almost zero chance of that money supporting retirement, unless there was enough to support a retirement there in the first place.
This section boils down to one hard question; Are you primarily trying to preserve wealth or create wealth? While most people would say both, investing doesn't work that way. There is no investment that creates wealth without any risk. There is no sure thing.
Investors must put capital at risk in order to expect real returns.
There are three factors in determining the right amount of risk for an investor. They are:
1. The Investment Time Period
The length of time available to the investor is a prime consideration in the amount of risk an investor should take. It is a common misconception that time diversifies risk. It is true that an investor can afford to take on more risk when they have a longer investing time. However, the reason is not that time diversifies risk, but that time increases the probability of creating wealth, which in turn allows an investor to tolerate more risk. If the time until the investment goal is long (5 years or more), the investor can afford to take on the standard amount of risk associated with market investing. If the time until the investment goal is shorter, a lessor amount of risk is appropriate. Moving from an equal mix of stocks and fixed income investments at five years to a completely fixed income portfolio a year or two from the investment goal is considered a wise move.
2. Picking the highest return for a given level of risk
Investors have come to think of risk as downside risk only, but there are a few types of investments where the upside risk (potential) is greater than the downside risk because of the infinite maturity of the investment, such as common stock or real estate. An infinite maturity investment is one that can be held forever, as opposed to a bond or CD which matures at some set date. Infinite maturity investments have no limit on what they can be worth in the future. These investments provide a distinct advantage for a long- term investor when compared to investments with similar risks but limited upside potential. Think about it. A bond will be worth $1000 at maturity, no matter what it is worth today. A stock has no maturity, and therefore no limit on what it can be worth. The advantages of investments that compound forever versus investments with fixed maturities can be summed up in the following:
Fixed income investments (with fixed maturities) have produced long term average annual
returns of 5% over the last 100 years.
Common stock (with infinite maturity) has produced long term average annual returns of 12% over the last 100 years.
$1 invested in bonds should produce $5 in 30 years.
$1 invested in stocks should produce $30 in 30 years.
Some of you may look at the benefits of risk and think, "Why not take on the riskiest investments we can find in order to get the biggest return?" As I previously stated, the smart investor looks for the best return for a given level of risk. Investing in commodities (where 90% of investors lose money), derivatives, local investment partnerships or shady land deals may have a greater expected return than common stock (a highly debatable point), but definitely has a greatly increased level of risk. A little more return for a lot more risk is not the way to increase wealth and still have a reasonable chance of preserving your current wealth.
3. Risk tolerance level and understanding
As previously stated, risk is the uncertainty of an investment return, i.e. the ups and downs of an investment's value over time. People drive themselves crazy figuring out the amount of money they gained or lost in a single day. But remember, as long as you plan to hold the investment past the end of the day, any gains or losses are just "paper" gains or losses. They are unrealized unless you cash out. Unless you happened to purchase long term bonds in 1980 paying 17% for thirty years, there is no investment worth holding, if creating wealth is your goal, that will not fluctuate considerably in value during the time you hold it.
The longer the holding period for an investment, the less concerned one should be at the short term fluctuations.
Just as Dorothy clicked her heels and chanted "there's no place like home", the investor must learn to repeat the chant "stocks go up more than they go down". Two years from now 60% of stocks will be priced higher, ten years from now 90% of stocks will be priced higher, and 25 years from now 95% of stocks will be priced higher than today. This has been a truth longer than our country has been in existence. Ignore the bumpy ride under the assumption that the bumps up have always been bigger than the bumps down, on average.
It has been over 400 years since the first stock certificates were traded. In those 400 years there has never been a 20 year period in which the stock market averaged less than 10% return per year.
If you still get queasy at the thought of your life savings see-sawing up and down in value on a short term basis, you may be better off putting your investment decisions with a trusted investment professional. Obviously most people do this, since there are now more mutual funds than stocks. The key is finding a manager that adds more value to your investing than they extract in fees. This is not as easy as you might think, over 80% of mutual funds under-perform the stock market over the long run.
If the idea of moderate risk not only appeals to you, but excites you, you may have the gambling mentality that so many bring to investing. This is the downfall of many investors. The gambling instinct increases an investor's propensity for short term trading, inappropriate long shot investments, and other proven losing strategies. Again, a trusted professional (assuming they don't have this problem) may be your best choice.
Fear and greed are two sides of the same coin, and are THE main reasons for investment failure. The next section will address the ways to stay out of these traps.
Mention the word investing and most people either immediately feel one or both of two emotions; fear or greed. Investing is supposed to be a science, but people either treat it like a lottery, hoping to get lucky, or they treat it like a bad smell, and stay as far away as possible. Understanding these emotions can help you avoid the traps.
Greed is the prime motivation for the "get something for nothing" crowd, taking risks with
the hope that they'll get lucky and hit it big. People operating under the greed mode are not necessarily bad people,
or even greedy people. It's just that they don't understand what investing really is.
Investors are loaning their capital, at a risk, to businesses, who in turn compensate the investor for taking the risk.
Reality: No lucky winners. No getting something for nothing. No making a quick killing. Of course, we are all pleased as punch if we do hit a big one, but to base an investment philosophy on these rarest of rare surprises is a proven loser.
There is a classic novel, called Wiped Out!, written in the sixties by an anonymous author, in which a man inherits $60,000 (big money in the sixties) and in a little over a year lost every penny through a series of short term stock trades feeding on his gambling mentality.
The other side of the coin is fear. The seeds of fear for most investors comes from dipping the big toe
of their savings into the pool of investing - only to have a shark bite it off! They take a tip on a hot stock
from a friend or relative, get burned, and conclude that investing is something to be avoided at all costs. That
first exposure turns them sour and they attempt to create wealth in ways that incur more risk than stock market
investing, but seldom provide the same return that a long term investing strategy in the stock market would provide.
Make no mistake about it, investing in a single stock, on the advice of a so called "expert" is extremely
risky and almost always ends in disaster.
Reality: Taking a more rational modified approach to investing greatly reduces the risk, and should remove the fear and greed that so many potential investors cannot overcome.
A successful investing strategy is not a simple thing. It involves having extensive historical knowledge of
investing, having the proper discipline, perspective, strategy, and an understanding of the odds of success.
Having a disciplined investment strategy that removes fear and greed from the investment decision is crucial to reducing risk while not sacrificing the returns available from common stock. There are successful investing strategies that minimize the costs of investing and help add to the bottom line in terms of increased returns. No truly successful plan promises instant riches; the creation of wealth takes time.
The actual components of successful investing is a topic addressed in another publication. For a copy of "Investing in Common Stock", a Total Quality method for portfolio management, contact Sharp Investments at 503-520-5000.
Is the management of your retirement fund (which may be you) confusing risk with safety?
If your investment goal is to retire with a million dollars, CD's or bonds are not the way to get there unless you already have a million dollars. Proper application of risky investments are a requirement for creating wealth.
Even for the short term retirement portfolio, some risky investments are needed to preserve capital and allow a retirement income to increase along with cost of living increases.
The reverse is also true. A portfolio of CD's and limited partnerships is usually not a properly managed portfolio. A balance of no-risk and high-risk seldom outperforms a more moderate balance of risk in a portfolio. Common stock has proven to be the highest yielding investment for the risk over time. Riskier investments, such as speculative derivatives, futures, precious metals, and others do not pay off for the level of risk taken. Therefore, any portfolio with more than a very small portion in these high risk investments is not being properly managed.
Proper management of a retirement portfolio takes into account investment time frames and goals, minimizes costs, and maximizes long term returns for a prescribed level of risk. Sharp Investments (503-520-5000) can help you evaluate whether your portfolio measures up or is in need of proper management.
o Without a Qualified Retirement Plan, a comfortable retirement income is difficult to attain.
o There is no real return without risk.
o Retirement funds can be at risk, but still be safe.
o Appropriate levels of risk are unique to investment goals.
o Common stock provides more return than other investments for the same level of risk.
o Without the right investing attitude, chances of success are slim.
o The key to a comfortable retirement income is using before- tax savings to invest in common stock, which is the best long term way to create wealth.