Investing for retirement
First published .I’m writing this page so I have something to point to when friends want help planning for retirement.
First of all: investing feels complicated, and the financial services industry is littered with people who want to take your money. Don’t take financial advice from anyone who isn’t legally obligated to put your interests ahead of their own – including me! – and especially don’t pay such a person for advice. Do your homework. If you spend a bit of time reading, you’ll be able to make better informed decisions on your own.
That said, here are some notes based on my own reading and experience, which I hope will get you started down the right path:
The basics
Investments come in a large variety of “packages”, but there are three basic underlying types of assets to consider:
- stocks
- bonds
- cash
Stocks represent a share of ownership in a company. They pay dividends and their price fluctuates with the market. Bonds represent a share of corporate or government debt. They pay a regular “coupon” and their price fluctuates based on interest rates. “Cash” means liquid currency (whether in a bank account or in physical notes). Its value changes with inflation.
For long term investing, you want a mix of all three types of assets. This is because cash loses value with inflation (even if it’s earning interest in a bank account). Stock prices rise with inflation, so they’re better than cash for a long-term investment. But stock prices fluctuate randomly and sometimes crash, so they’re a risky investment. To minimize this risk, you also want to invest in bonds, since they pay dividends regularly and their price tends to rise when stock prices fall.
Asset allocation
The exact percentage of your total assets that you have in stocks, bonds, or cash is called your asset allocation. Deciding on your asset allocation is your most important overall investment decision, because it determines your personal ratio of risk and reward. Generally speaking:
- the younger you are, the more risk you can afford, and the greater percentage of stocks you should have
- as you age, you should slowly shift more of your asset allocation to a greater percentage of bonds (to minimize the risk from stocks)
- cash essentially always loses value so you should only keep enough of it to get you through an emergency (perhaps 6-12 months of your current expenses), and invest everything else in stocks or bonds
(I will therefore assume you have a cash emergency fund for the rest of this, and ignore cash when talking about asset allocation.)
A simple starter investment
As a rough estimate: you probably want around 65% stocks, 35% bonds at the time you retire. So if you have 30 years until retirement, you could for example start with 95% stocks and 5% bonds, and shift 1% a year from stocks to bonds, to have the 65-35 ratio at retirement.
There are mutual funds that will do this shifting automatically for you. They usually have names like “Target Retirement 20XX”, e.g. Vanguard’s Target Retirement 2055 fund.
Investing in one of these funds is probably the simplest way to get started: just pick a fund for the year you want to retire, put all your non-cash assets into it, and invest more in it whenever you can. You can also use the asset allocation in these funds as a guide to set your own asset allocation, if you prefer to manage the ratio yourself.
Rebalancing
If you don’t invest in a fund that provides this automatic annual shifting, you have to manually keep your investments in line with the asset allocation you decide on.
For example, suppose that you are targeting 90% stocks and 10% bonds. You start by investing 900EUR in stock-based investments and 100EUR in bond-based investments. But stocks have a strong year, and so one year later, your stock-based investments are worth 1015EUR, while your bond investments are worth 105EUR. Thus your total investments are worth 1120EUR, of which your stocks are now 1015/1120 = 90.625%, while your bonds are 105/1120 = 9.375%. They’ve drifted away from your 90%/10% asset allocation. Over time, they will drift even further, depending on the market.
Realigning the current value of your investments with your asset allocation is called rebalancing. It’s important to rebalance once in a while, and there are a couple of ways to do it.
One way is to sell some of the stocks to buy more bonds, to bring them back to the 90%/10% ratio. (In this example you’d exchange 7EUR of stocks for bonds: 1120 * 10% = 112, and 112 - 105 = 7, so you need 7EUR more in bonds.)
However, selling assets to buy others usually means paying taxes on the sale, so it’s best not to do this too often. As a rule of thumb: only sell to rebalance when your ratios are off by more than 5 percentage points, and don’t do it more than once a year.
As long as you’re actively contributing to your investments, the other way to rebalance is to calculate how to distribute your contribution to that it restores the asset allocation.
Say, for example, that after a year, you’re ready to add another 1000EUR to your account. This will bring the total value of your investments up to 1120 + 1000 = 2120EUR. Thus you want to end up with 2120 * 10% = 212EUR in bonds, so you’d invest 212 - 105 = 107 into bonds. Likewise, you want to end up with 2120 * 90% = 1908EUR in stocks, so you’d invest 1908 - 1015 = 893EUR in stocks. Now you’ve rebalanced without having to sell any of your existing assets.
Mutual funds and ETFs
But what investments do you actually put this money into? If you’re an average person just looking to save for retirement, investing in mutual funds is the best way to do it.
A mutual fund is a company that invests in a mix of underlying assets. Instead of buying those assets directly, you can buy shares in the mutual fund. The fund will then use your money to purchase more assets. The share price of the mutual fund is determined by the value of the assets it is invested in. So effectively, when you buy shares in a mutual fund, you’re pooling your money with other investors who want to invest in the same kinds of asset. This allows you to have much greater diversity in your investments than you would if you were to buy individual stocks and bonds yourself.
Fees and “expense ratio”
Mutual funds are not free to run, of course. Thus they charge a fee to their investors, which is often expressed as an “expense ratio”: the percentage of the fund’s yearly profits that the fund uses to cover its expenses.
You want to invest in funds where the fees are as low as possible.
This is because, in the long run, the value of your investments mostly consists of the growth in the underlying assets. This growth is exponential, and since expense ratios are expressed as a percentage, they grow exponentially too. An expense ratio that sounds low, like 2%, can eat up a huge portion of your investment in the long run – perhaps 50% or more over several decades!
Unfortunately, there are many funds out there run by financial services companies that charge exorbitant fees like this.
Ideally, the expense ratio should be much less than 1% and there should be no additional, extra, or hidden fees. You must read the fund’s information carefully to make sure the expenses are reasonable. As a benchmark, the funds I’m currently invested in have expense ratios of:
Stay away from any fund with an expense ratio much higher than that.
“Index” vs. “Managed” funds
A mutual fund invests in a broad mix of assets according to some strategy or rule. An “index” fund is a fund that invests in assets according to some index of a particular market, e.g. the S&P 500 stock market index. Whatever the index says the market consists of, in whatever ratios, that’s what the fund buys. Thus, the value of an index fund reflects the value of the whole market (as recorded in the index). If the market as a whole goes up, shares of the index fund go up too. If it goes down, shares of the index fund go down.
An “actively managed” or “managed” fund, by contrast, tries to buy and sell assets according to some strategy. The management tries to “beat the market”: they pick and choose which assets to invest in, hoping that their choices will result in higher profits than the market average.
No one can beat the market in the long run. Sometimes managed funds perform better than index funds for a while, but no one can consistently pick better assets over decades. Thus my advice is to just buy index funds, and avoid managed funds, which usually have higher fees.
ETFs
“ETF” stands for “exchange-traded fund”. It is a type of share in a mutual fund that can be traded on an exchange, much like stocks. Also like stocks, the share price changes in real time. Regular shares, by contrast, only change value once a day after markets close.
My advice is generally to avoid investing in ETFs. If you’re investing for retirement, you get no advantage from the real-time pricing, and there are usually brokerage fees for buying and selling them.
The only reasons you might want to buy ETFs instead of regular shares in a mutual fund are:
- to start investing in a fund where the minimum investment in regular shares is too high for you
- to obtain a lower expense ratio (since these sometimes differ between classes of shares)
Further reading
I said you should do your homework. Here’s your first assignment: read If you can, by William Bernstein.
Bernstein outlines some basic ideas and recommends a bunch of further reading. (The book by John Bogle is especially worth reading, if you can stomach a whole book about mutual funds.) Keep reading his recommendations until it’s no longer useful.
Note: Bernstein’s booklet, and most of the other books that he recommends, are focused on the US, which is where I started and where my investments still are. The basic principles carry over to other countries, but the details – especially about particular funds, taxes and tax-sheltered accounts – will be different. If you need more specific advice for your country, look for advice that is in line with Bernstein’s approach but has the details you need.