How to Invest for the Future

Here’s how you start thinking about how to achieve your investment goal, whatever it may be. You may be saving and investing to buy a new home, to put your kid(s) through college, or to leave a legacy for your children and grandchildren.

For most people, however, a primary goal of investing (as well it should be) is to achieve economic independence: the ability to work or not work, to write the Great (or not-so-great) American Novel… to do whatever you want to without having to worry about money.

For now, the pertinent question is this: Just how far along are you toward achieving your nest-egg goal?

Estimate how much you’ll need

Please think of how much you will need to withdraw from your nest egg each year when you stop getting a paycheck. Whatever that number is ($30,000? $40,000?), multiply it by 20. That is the amount, at a minimum, to have in your total portfolio when you retire. (Or even 25 times, preferably.)

Now multiply that same original-year withdrawal figure ($30,000? $40,000?) by 10. That is the amount, at a minimum, to have in fixed-income investments, including bonds, when you retire.

We’re assuming here a fairly typical retirement age, somewhere in the 60s. If you wish to retire at 30, you’ll likely need considerably more than 20 times your annual expenses (or else very wealthy and generous parents).

Assess your time frame

Okay. Got those two numbers: one for your total portfolio, and the other for the bond side of your portfolio at retirement? Good. Now how far off are you, in terms of both years and dollars, from giving up your paycheck and drawing on savings?

If you’re far away from your goals, you need lots of growth. If you currently have, say, half of what you’ll need in your portfolio to call yourself economically independent, and you are years from retirement, that likely means loading up (to a point) on stocks if you want to achieve your goal. Vroom vroom.

If you’re closer to your goals, you may have more to lose than to gain, and stability becomes just as important as growth. That means leaning toward bonds and other fixed-income investments. Slooow down.

For those of you far beyond your goals (you already have, say, 30 or 40 times what you’ll need to live on for a year), an altogether different set of criteria may take precedence.

Factor in some good rules

No simple formulas exist that determine the optimal allocation of bonds in a portfolio. That being said, there are some pretty good rules to follow. Here are a few:

  • Rule #1: You should keep three to six months of living expenses in cash (such as money market funds or online savings bank accounts like Ally or EmigrantDirect.com) or near-cash. If you expect any major expenses in the next year or two, keep money for those in near-cash as well.

    When you read near-cash, think about CDs or very short-term bonds or bond funds.

  • Rule #2: The rest of your money can be invested in longer-term investments, such as intermediate-term or long-term bonds; or equities, such as stocks, real estate, or commodities.

  • Rule #3: A portfolio of more than 75 percent bonds rarely, if ever, makes sense. On the other hand, most people benefit with some healthy allocation to bonds. The vast majority of people fall somewhere in the range of 70/30 (70 percent equities/30 fixed income) to 30/70 (30 percent equities/70 fixed income).

    Use 60/40 (equities/fixed income) as your default if you are under 50 years of age. If you are over 50, use 50/50 as your default. Tweak from there depending on how much growth you need and how much stability you require.

  • Rule #4: Stocks, a favorite form of equity for most investors, can be very volatile over the short term and intermediate term, but historically that risk of loss has diminished over longer holding periods. Over the course of 10 to 15 years, you are virtually assured that the performance of your stock portfolio will beat the performance of your bond-and-cash portfolio — at least if history is our guide.

    It shouldn’t be our only guide! History sometimes does funny things. Most of the money you won’t need for 10 to 15 years or beyond could be — but may not need to be — in stocks, not bonds.

  • Rule #5: Because history does funny things, you don’t want to put all your long-term money in stocks, even if history says you should. Even very long-term money — at the very least 25 percent of it — should be kept in something safer than stocks.

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