Investing for Life Creating Assets
By James R. Cook, CFP®
Senior Manager Larger Employers & Mergers and Acquisitions
There is no way of getting around it, saving and investing have certain unavoidable complexities. Financial Planners are often asked seemingly simple questions:
There is a simple answer to these questions, though it is not a very helpful one —*It depends!* It depends on what your goal is, when you want to achieve it, how you feel about losing money in an investment. There are more questions, and of course the answers are different for everyone. Because the timing of your goals play such a significant part in these questions, this two-part article will focus on important decisions in two major timeframes in most individuals’ lives:
In this first article, we will focus on the Accumulation Phase.
Unless you plan to work to support yourself until the day you die, you will need to have a plan to save and accumulate assets. In the second phase of your life, you will use these assets to create a stream of income that will replace your wages. In simple terms, this is saving and investing. Another way to think about it is deferring and investing.
Deferring may be a better way to think about your long-term savings, because it recognizes that most of us have a fixed capacity to earn money, so unless you want to work forever, you must defer spending some of your money now, to ensure that you have some to spend in the future, when you will not be working. The chart above gives a helpful illustration of this point. As the chart shows, your human capital (your ability to make money) declines over time. The green dotted line shows how your financial capital (your savings and investments) can grow over time if you defer some income. If your planning goes well, at some point—year 40 in the chart—the financial capital that you created through saving and investing, can replace your human capital. That point is retirement!
Saving and Investing
Saving and investing are not the same thing, but they do work together. If you are going to be successful about building a nest egg that can support your lifestyle in the future, you should choose a lifestyle now that does not spend all of your current income. You can call this approach saving or deferring, or just being wise, but it is the first step toward a secure future.
The second step is investing the money that you’ve decided not to spend. The goal of investing is to multiply the value, over time, of the money that you save. For most people, saving for retirement means saving for decades. A smart plan will allow the money you invest to increase over time, due to the power of compounding. Compounding occurs when the value of an investment increases because the earnings on an investment earns interest as time passes.
Here are two examples of compounding:
The lesson from these examples is that you must invest to accumulate enough assets to support your future lifestyle. The question then becomes: how do you invest?
The Role of Time
If your plan is to retire next year, how would you feel about losing 20% of the value of your retirement savings? That thought would give most people heartburn. What if you are thirty years old and your investments lost 20% one year? You might have a bit of heartburn as well, but the long-term impact of that loss is probably much less significant; you may have thirty more years of saving and investing to overcome that loss.
Every investment has a level of risk and reward associated with it. If you take on more risk, in general you are doing it for the potential, over time, of being rewarded with a higher return. Conversely, if you assume less risk, you are also assuming lower returns on your investment.
In the context of saving long-term for retirement, this means that the longer you have until you need to start spending your money, the more risk you can take, and the closer you are to needing your money, the less risk you should take. Let’s look at risk and return for some common investments in the 10-year period from 2007-2016.
You can see that in just this short period the lessons we have discussed hold true. Stocks have the most risk—you could have lost over 36% in one year—but also have the highest rate of return over time. On the other end, T-Bills have a very low return, and virtually no risk. If you had been invested in stock over this whole period, you would have received a nice return of 6.32% for the risk that you assumed.
Of course, each of us has a personal risk tolerance. Your tolerance for risk will also play a role in how you choose to invest.
So, where should you be invested? The first answer may still be the best: It depends. MMBB’s financial planners are here to help guide you. We can help you think about your goals, the timing and the other elements of risk tolerance, and guide you to investment choices that will fit you. Call us at 800.986.6222, or send an
Next Month: Investing for Life—Creating Income