It is very important to understand the difference between safety and risk when planning out your retirement portfolio. In recent posts, I have discussed some other key factors involving making the important decision of "Who to invest your money with." I would now like to make sure that you understand the difference between the actual investment vehicles that are available to you. More specifically, it is highly important that you understand which products are truly safe, and which ones are not!
First, I would like to start by explaining a very simple idea that makes it easy for the average investor to understand what options are available to them. We call it the "Pyramid of Investing". Much like the normal food pyramid, there are several levels on the Pyramid of Investing. The main idea that you must understand is which levels on the pyramid will keep your money safe and which levels will have your money at risk.
Remember, when it comes to retirement, it is important that you re-evaluate your position on the pyramid. If you have too much money at risk, you are going to be top-heavy. This is a "no-no" during your retirement years. Being top-heavy can cause problems especially if you plan to draw income off of your portfolio. In terms of a fixed income, which is what most retirees live on due to a stoppage in income coming in from work or employment, you must be able to take extra income needed from money that is safe or stable rather than money that is at risk and extremely volatile.
On the pyramid to the left, you will notice 5 different levels. The level on the bottom is the foundation of the pyramid. It lists the only 4 accounts that will keep the money that you put in to them safe. The accounts at the base are the only investment vehicles that offer safety of principal with consumer protection. You only lose principle if you choose to. As you make your way up the pyramid, the levels range from "ultra-conservative" to "high-risk" at the very top. We just mentioned that the appropriate rule of thumb during retirement and as you get older is that any money you draw off of your retirement funds or dollars should come from the very bottom levels on the pyramid, the foundation!
Taking this idea a step further, let's imagine that an unexpected event were to occur or that you needed to access your money (an investment you would like to purchase, long-term illness, etc.) If you need to take money from an investment or chunk of your portfolio that is exposed to the stock market, you may not be able to get it precisely when you need it or worse yet at the worst possible timing.
In these types of events, people who have too much risk in their portfolio can be "hand-cuffed" when they need to get their money out. If the market is performing poorly, you may not want to access the money from your investment portfolio. But, if you absolutely need it, do you really want to get it out when the market is performing poorly? In this case, you would be better off to wait for the market and "your money" to come back before you take it out. The situation is out of your control!
A good rule of thumb to follow is called the "100 age rule". As stated in a previous post, take your age currently and subtract it from 100. For an example, we will use a 60 year old. 100-60 is 40. In terms of safe money and risk money, you should now use 60 and 40 for your parameters. That means 40% of your retirement dollars could be allocated to some type of risk investment. The other 60% (your current age, or investors need to add 10 this if they are on a fixed income) could be in the foundation of the pyramid, in something that is safe and should not lose principal.
Going back to the pyramid of investing above, the 40% we are now talking about could be allocated amongst the other 4 levels of the pyramid. These 4 levels range from "ultra-conservative" (the layer just above the foundation) to "high-risk" (the tip of the pyramid). Depending on your risk tolerance and your individual situation, you may want to have some sort of risk associated with your retirement portfolio. With a strong foundation of 60%- 70% in our example, 30%- 40% of the dollars allocated to risk will not make your pyramid "top-heavy".
Taking it a step further, the 60% allocated to safety could go in one of the only 4 safe investment vehicles that are listed in the bottom layer of the pyramid. Depending on your situation, you may be able to have some of this 60% allocated in the 2nd layer, amongst the "ultra-conservative" layer of the pyramid.
I talk to a lot of people that are getting tired of the stock market. The biggest thing investors forget is that the stock market takes it away quick and gives it back slow. For example, if you lose 40% (100-40=60), it takes a 67% increase just to get back to even. When is the last time you earned 67% in a year? Better yet, if you did, were you disciplined to sell when you were up?
I am not against having dollars allocated in the right kind of risk-type investments. I have just come to respect the stock market for what it is. And quite frankly, a lot of people really have no business being in the market in their financial stage of life! The common misconception among many retirees is that they believe they have to have their money at risk in order to get a good rate of return. Well guess what? You don't as long as you are OK with a 5-8% average returns. Funny thing is most investors have no idea what their real return is on their money.
It is not lack of knowledge or not knowing about strategy or plan that causes failure. It is the illusion of knowledge that causes failure.
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