Elusive Wealth

So we have had one guide on retirement investment plans, which is available here. But knowing what to invest in is a different story. Now before I get into this, I will admit I am not a finance guru who will make you instantly rich (then again, no one is that much of a guru).  But I can outline my plan, which I believe is a realistic and valuable plan for most people who have been consistently saving over time. There are certainly a lot of variables in investing, and we cannot cover them all here. But I will try to cover the basics that should keep your retirement portfolio growing in the long term.

This article is the introduction to the series.  When we talk about retirement, there are a couple of factors that are important to understand:

1. Retirement does not just mean “quit working.”  On this site it really means finding financial freedom to do what you want to do. That could be reduced or no work hours. Or it could mean starting a business, volunteering, or opening a daycare for grandchildren.  Retirement is just a convenient word for that, but financial independence is the real goal.
2. Reality matters here. If you do not have enough money already saved and invested to be financially independent with a portfolio growth of 6 – 10% annually over ten years, then you won’t be done in ten years.

Before we get started on investing, let’s do some pre-work. Specifically we need to determine the following:

• Are you debt free or nearly debt free?
• What is your risk tolerance?
• How much money do you need to be financially independent?

Are you debt free or nearly debt free?

With 10 years left to go before retirement, you should be on your way to being debt free with the exception of a mortgage. This isn’t easy, and it isn’t reality for everyone. However, it is where you need to start.  Debt quickly cancels income, which hurts your ability to accumulate wealth. Debt represents risk to you. Paying off debt gives you a guaranteed return matching your interest rate (unless the interest is deductible for you). Aside from overextending yourself and not having cash on hand (an emergency fund), there is little risk to paying off debt.

Some people want to compare the interest rate with the return on investments they could have.  Usually they forget risk in that equation.  For example, if you have a home equity loan at 8% from rates before the housing market crash, payments to that loan “earn” 8% while the stock market jumps up and down.

But really the bottom line is that you cannot feel financially independent with significant debt, and debt makes getting there that much more difficult. A mortgage is the only debt that you should not pay off before investing, since the home tied to the mortgage will gain value over time.

What is your risk tolerance?

This is a huge factor in deciding what to invest in. Many people moved happily along with their 401(k)’s until the 2001 tech crash and the latest recession turned them into “201(k)’s”.  If you have a low tolerance for risk, your investments need to reflect that. However, the sobering truth is that if you tolerate no risk in your portfolio, you will get little to no growth relative to inflation. Your entire contributions will need to support your financial freedom. A lot of people have moved their retirement investments into cash and conservative investments because of low risk tolerance. No one gets wealthy by investing without risk. Whether that risk is by investing time and energy into a new business, focusing intensely on your career, or putting money in the stock market.

Let’s say you are open to risk. Is there such a thing as too risky?  There absolutely is. Bernie Madoff and Enron have shown us this. No one person, no one stock should have all of your money, ever! They key is to spread the risk across areas that you are comfortable in.

So pick where you are at with one of the following (this will be important in future editions of this series):

• Conservative – You don’t ride roller coasters, and you tremor in fear at the thought of your retirement investments looking like a roller coaster.
• Moderate – You enjoy the thrill rides and roller coasters, but only on a few vacation weekends out of the year. You aren’t willing to put half of your money “at risk.”
• Aggressive – You realize what goes up can and will come down, you don’t read the news or you disregard the news, and you believe in the economic machine of our global economy

How much money do you need to retire / be financially independent?

This is not as difficult a question as it seems. Though you can save more to be comfortable and to reduce risk, the simple answer is that you need enough money so that the earnings meet or exceed the income of your “day job”. You can get buy with a bit less if you have no debt at all and most of your income is going to increasing your savings. A common suggestion is that you be able to replace 80% of your pre-retirement income. My suggestion is aim for 100% and re-evaluate every 5 years. If at that point you can replace 80% or more and are comfortable with that amount (for the rest of your life) then you are set.

Types of Investments

We are almost at a point where we can start looking at investments. When we talk about investing, while keeping in mind your risk tolerance, we must identify the key requirements of any investment that you make:

• You must understand the investment. You don’t have to understand it enough to run a mutual fund, for example. But you must understand what it invests in, how it grows, how the management company makes its money, and how the financial adviser that suggested it makes his/her money.
• You must accept volatility. Only a bank account, money market account, or a CD is going to have a guaranteed or nearly guaranteed rate of return.  Assuming you decided that your risk tolerance is at least enough to allow some growth over inflation, you will have to accept volatility in the market of whatever the investment is.

There are many people who are quite savvy about investing and meet both of these requirements hands down. This article series  is not really intended for that audience — those folks already know how to make money in the market, likely in both down and up markets. If you like your ETFs, your hedge funds, your variable annuities, and your gold, you won’t like my plan.  But if you are like the majority of people out there, you have a cursory knowledge of most investments and you do not want to become an expert in many different investments. So it really comes down to just a few investment types that I would recommend:

• A U.S. Market Index Fund
• An emerging market index fund (foreign markets like Brazil, China, India)
• Real Estate (either a Real Estate Investment Trust, REIT, or renting out property)
• Guaranteed fund, CDs, Money Markets, and Savings Accounts

Whoa!  I left a lot off of the list, right?  I don’t believe so. The reality is that investments beyond this group get more difficult to understand and manage. As we get into the remaining articles in this series, we will cover these investment types in more detail.If you wish to get more fancy than these options you certainly can. But my plan, and my recommendation to anyone, for the most part sticks within these categories.  I will describe later in the series some ideas on how to get a bit more aggressive, or how to “try out” other investments within your retirement portfolio. But as we cover this series the biggest question will become: what kind of mix of investments do you need?  This all comes down to your risk tolerance and the years you have left until financial independence / retirement. And that is why I am covering these topics in stages. So keep an eye out for the next article in the series!