Retirement 101: We need to talk… about investing

Put your savings to work

You’re doing great.  You’ve figured out what your current yearly expenses are. You’ve dreamed up your retirement.  And you’ve adjust your expenses to account for lifestyle changes in that retirement. You used that information to figure out how much you need to save each month in order to retire at your planned retirement age.

But we’re still missing one crucial bit: What are you going to do with that savings?

Buckle up, it’s time to invest!

“Why are we investing our retirement savings?  Isn’t the stock market risky?  Complicated?  Why don’t we just leave our retirement funds in a nice, simple easy, federally insured savings account?”

Sure, you could try saving for retirement in savings account. Let’s take a look at how that would work. Consider Bjorn, from our previous example about how to figure out when you can retire based on how much you can save. He has $125,000 already saved, and is needs to save $1.3 million for retirement. He’s 33 years old, and plans on putting $800 per month into his retirement account.

Let’s try that again. Bjorn has discovered iBonds and TIPS, which are investment products run by the US treasury.  They are basically as safe as a savings account, and are guaranteed to keep up with inflation.  Since these products just keep up with inflation, that means Bjorn’s inflation adjusted returns are exactly zero.  We don’t even have to use a compound interest calculator, since there effectively isn’t any interest. We just take his goal of $1.3 million, subtract his current savings of $125,000, divide by his $800 monthly contribution, and… It will take him 1469 months to hit his retirement number. That’s more than 122 years.

Let’s try that one more time.  Assume Bjorn still wants to stick with his extremely safe option that tracks inflation. He’s still too scared of market volatility to invest in stocks. What then can he do in order to reach his retirement number by age 65? He’ll have to increase his contributions… to $3,060 per month.

Well, that’s not going to work.

Bjorn has come to his senses. He decides to embrace the slight risk of a well-diversified stock portfolio, knowing that he can go back down to his planned monthly contribution of $800 and hit his retirement number at age 58. And if the market happens to hit a downturn right before then, he’ll just plan to keep working a few more years to make up the difference. The risk of a possible set-back in the market is well worth it as compared to the guaranteed set-back of having to save $3,060 a month, which he just cannot afford!

Compound interest

You may have heard of the magic of compound interest before. But just in case you haven’t, compound interest is what happens when you earn interest this year on interest that you earned in prior years. Here’s an example with some really simple numbers: If I have $1000 and every year it earns 10% interest, then after the first year, I’ll have $1100. (The initial $1000, plus $100 in interest.) Then, at the end of the next year, instead of getting another $100, I’ll get $110.. (That’s ten percent of the $1100 from last year, as opposed to ten percent of the original balance.)  As the balance continues to increase, each year’s interest payment gets calculated on new balance, not the original balance.

After 40 years of compound growth at 7%, $5000 becomes nearly $70,000.  And that’s if you just leave it alone, adding nothing at all over the course of those 40 years! Meanwhile, if growth weren’t compound, that $5000 would only be worth $18,650. 

Even if you already understood how compound interest works, there’s nothing like a good example, such as Bjorn, to really drive the message home.  Compound interest is the tool we need in order to plan on a reasonable retirement. And the only way to get the higher returns needed to beat inflation is to accept some of the risks that tag along. There just aren’t any investments that return that kind of interest in a 100% guaranteed safe way. Anyone who promises otherwise is lying, and probably selling you something even riskier.

The good news is that investing over the long term in a well-diversified portfolio is relatively safe.  The stock market as a whole tends to average 10% returns, year over year. That’s true for the entire recorded history of the stock market, not just a few cherry-picked time ranges.  (The bond market is even safer… though with lower expected returns.)

“But what if after saving for 10 years, there’s a big crash and my retirement fund loses half of its value!!! 

Good question. And the answer about the market crashing isn’t so much “what if” but “when.” Because it does crash.  That’s to be expected. Know it’s coming, and be prepared to ride it out. Here’s why: After 10 years in the market, your savings will have probably at least doubled. So this hypothetical “crash” only brings you back down to where you’d be if you hadn’t invested–if you’d put your money in a savings account.

More importantly than that, though, is that recovery happens.  The market crashed in 2008. Some people panicked and sold off their investments. It’s human nature to try to avoid loss.  Staying in the market was hard, but for  those who did, we’ve skyrocketed well past the point where the market was before the crash. In a crash or downturn, your loss only becomes real if you sell you holdings while they’re down. If you can wait until they come back up, you haven’t lost anything. Decade after decade, every crash has always been followed by a recovery and further growth. On the whole, the market goes up. It always has.  And though the future isn’t guaranteed, the kind of situation that would lead to the whole market crashing and not recovering is the kind of situation that leaves you with far bigger worries than retirement funds. (Time to buy a bunker in Montana?)

Does higher risk bring higher returns?

Yes… Maybe. Higher risk investments come with higher potential returns.  But be aware that they also come with worse potential returns. That’s why they’re risky! At some point, it changes from high risk/high return to straight up gambling. These are the ones that make the headlines. (They are also the ones to ignore.) Remember, Lottery winners make the news too, but only a fool plans their life around winning the lottery.  Don’t get me wrong. It’s fine to daydream about what you’d do with a sudden windfall. It’s fine to play the lottery if you can afford it.  Likewise, if you want to invest in penny stocks, cryptocurrencies, or other speculative products, go for it! Just do it outside of your retirement plan.

Your retirement investments should be part of a solid plan to get you through retirement with greater than 95% chance of success. Speculative gambling cannot give you that kind of assurance. Only speculate with money you’re OK with losing–and after you’ve paid for everything else (housing, food, bills, regular retirement savings, etc.).

Lottery winners, Crypto “whales” and GameStop players all get featured in the news because they are outliers.  Not featured in the news: The ratio of people who threw away their retirement funds on speculative gambling that didn’t work out, as compared to those few winners that get highlighted. (Also, those Crypto whales and the like are in the news because their gains have already happened. If you jump on board at that point, you’re gambling that something that already increased an unlikely amount is going to continue to increase an even more unlikely amount. Sure, it happens sometimes. And sometimes a slot machine pays out twice in a row. Either way, it’s quite a gamble. If you absolutely must try your hand at picking a “big winner,” the trick is to get on board before everyone else knows about it.)

The downside to individual stocks

“So, stocks are great, and we should pick safer ones. Ones that may not make the news like GameStop, but will still have good long-term gains. Great. Which specific ones?”

All of them. Or at least, a very large portion of the list of major companies.  Here’s why: We already established that the market as a whole tends to go up an average of 10% per year.  But there’s no guarantee that any particular stock will follow the average. In fact, it’s pretty much guaranteed that they won’t.  Even large once-trusted companies sometimes go belly-up.  However, for any given company whose stock tanks, there’s another company or group of companies whose gains more than make up for that loss. That’s how average growth works.

The way to mitigate the risk of having a few “big losers” in your portfolio is to diversify.  The broader the range of different stocks that you own, the more likely you are to hold enough “winners” to balance the “losers.” The more diversified you are, the more likely you are to have similar returns to the market as a whole.

Unfortunately, if you want to know which specific companies will be the ones that do the heavy lifting… you can’t.  You can try to make your best guess based on what the market is doing and each individual company’s relative “health”…But there are no guarantees. People who try to pick the perfect small selection of stocks to match or beat the market end up underperforming the market average by average 1.5%. You might think that more active investors who buy and sell more frequently to try to take advantage of volatility would do at least somewhat better, but no. They actually do worse.  Way worse. These market-timers tend to underperform by 6.5%.

Since we’re planning for retirement–not playing “stonks” for the excitement of massive “gainz”–the best course of action is to aim for that whole market average return. It gives us a nice solid, relatively predictable, long-term return that we can rely on for planning purposes. Even better, if we can manage to set up a portfolio that tracks the whole-market average returns, we’ll be doing better than most investors. And the best way to ensure a return that tracks the whole market is to buy a little bit of everything on the market.

“OK, you’ve convinced me. I want to invest in the stock market as a whole.  How do I buy one of every stock?”

Good news! You don’t have to! (And trust me you wouldn’t want to!  There are around 2800 stocks on the NYSE alone.  Keeping track of everything would be a nightmare. ) Enter: the index fund. For those who haven’t heard about them before, here’s a quick simplified description of how they work.  An index fund is similar to a company’s stock in that you can buy and sell shares on the open market. But instead of each share representing your ownership of a portion of one company, it represents lots of little positions in many, many companies.  The index fund manager buys and sells shares of the hundreds or thousands of companies on its index (which is just a fancy market term for a well-defined list), so you don’t have to.  The value of an index fund represents the aggregate value of the all the stocks held by that index fund.

Some index funds track the whole US market. Some track the whole international market. You’ve probably heard of the Dow Jones Industrial Average. That’s a market index (a specific list of companies) that analysts use as a representative sample to track the performance of the overall market… and there’s an index fund that mimics it. Same for the S&P 500.  Some index funds track much smaller segments, such a certain size companies, particular technologies, health care, green energy, emerging markets, and on and on. You can pick and choose all sorts of index funds if, for example, you have a very good reason believe that a certain sector is about to outperform the market as a whole. (Of course, doing so means risking lower than average returns if your chosen sector underperforms.)  Another strategy is to divide your money across a few different markets (US, International, Emerging Markets) as a hedge against losses in any one of those categories. It’s easy to get wrapped up in the minutiae of all the possible theories about the “best” way to invest. We’ll get more into that in a later section about optimizing your portfolio. When you’re just getting started, and particularly if you still have more than 10 years before retirement, sticking with an index fund that tracks the whole US market (and one for the US bond market, if you’re especially risk-averse) is more than good enough.

What’s the difference between an index fund and a mutual fund?

Trick question. There isn’t a difference. An index fund is a type of mutual fund (though it can also be what’s called an ETF, or Exchange Traded Fund. More on that later).  But let’s back up a step. What is a mutual fund? Mutual funds are funds that are made up of collections of other equities (stocks and bonds, etc.) Sound familiar?  Isn’t that what we said an index fund is? Well, yes.  After all, we also said an index fund is a type of mutual fund!  The main difference for the regular investor is that index funds track a pre-determined list of stock and/or bonds. The criteria for a company’s inclusion in an index fund are determined when the fund is first started, and they don’t typically change. A regular mutual fund, on the other hand, is typically “actively managed.” That means that there’s an analyst or team of analysts in a office somewhere whose job is to constantly review the list of stocks in their fund’s “basket” and try to “pick winners” and remove “losers”. This can create a lot of churn, when companies are added or removed from the fund quickly.  Actively managed funds tend to claim to be able to beat the market, or to be “safer” with less volatility or downside risk.  Sometimes this is even true… though more often, actively managed funds actually underperform. And there’s another catch.  Someone has to pay those analysts who are managing that fund.  And someone has to pay the taxes that are incurred every time a mutual fund sells off a stake in a given company.

That someone is you. 

Index funds, on the other hand, tend to have much, much lower fees. In recent years, fund managers like Vanguard and Fidelity have released a few broad market index funds that have 0% expense ratios. But even their regular offerings come with fees that are less then a tenth of a percent.  Vanguard’s very popular Total Stock Market Index Fund (VTSAX) has an all-in expense ratio of 0.04%.  The reason they can have such low fees is that they don’t have to pay that team of analysts to try to beat the market.  They just hold a balanced collection of stocks that represent the whole market. And no matter what the market or any individual stock is doing, they just stay the course. No action needed, so no cost incurred. 

• • Morningstar is perhaps the most well-known investment research sites for individual investors. They offer a decent amount of information for free, but will also try to upsell you on their premium subscription on every page.  Don’t do it! You almost definitely don’t need to pay for their information in order to get the info you need for retirement planning.
  • Fidelity is one of the biggest discount brokers around.  Their research tools provide easy access to details about stocks, bonds, and funds from all major fund managers.  Because they also have their own line of mutual funds and index funds, they will often compare the fund you’re looking up with one of their own. It’s an attempt to get you to go with their version instead of the one you’re looking up, so be careful. That being said, Fidelity’s funds are very competitive with the other major players’ funds, and could be worth a look.
  • MAXfunds is set up specifically for mutual funds. You won’t find charts or data for regular stocks here. The site looks a bit dated, but the information is good and easier to read than most.  The company also provides financial advisor services, so watch out for attempts to upsell!

Visit any of the above sites and type a fund’s ticker symbol into their search bar. Some critical stats to check are:

• • Expense ratio – How much it costs them to manage the fund… which is passed on to you
  • Transaction fee – This can vary depending on where you buy the fund. Vanguard funds bought through Vanguard will have no transaction fees, for instance. But when bought via Fidelity, many will have an extra fee per transaction.
  • Other load and fees – Some mutual funds have other fees, or “loads”, to help increase their profits. Not yours, theirs. Avoid funds with other loads and fees!
  • Minimum investment – Many funds will have minimum investment amounts, often in the $1000 to $3000 range. This isn’t a big deal for long term retirement investing, though it may mean you have to wait a few more months before you can purchase invest in that particular fund, if you don’t have enough cash laying around to meet the minimum. Once you are invested in an account with a minimum, subsequent investments can be smaller. It’s not a transaction minimum, but a minimum total investment. If the idea of minimum investments puts you off, there are also plenty of index funds that don’t require a minimum. There are also “Exchange Traded Funds,” which are almost the same as mutual funds except that they are set up in such a way as to be able to be traded in real time on the stock market, instead of once per day (which is how the mutual fund market is set up.) ETFs have no minimums, except that some brokers won’t allow the purchase of partial shares. So if an ETF is trading at $120/share, and you have $200 to invest, you will only be able to buy one share. (Many brokers have now moved to a system that allows partial share purchases, though. Something to look out for when you choose a broker!