Seven Principles of Retirement Investing

This article is intended to share the basics of retirement investing for someone who wants to get started. Retirement investing is a lot easier than you may think. Even basic financial knowledge can make a big difference in your retirement savings. I’m not a professional investor, but investing and financial literacy are my passions. My goal is that this article will help put more money in your pocket.

Photo by Sharon McCutcheon on Unsplash

Here are seven principles to get started with retirement investing.

Principle 1: The only person that cares about your money is you.

The financial industry makes a killing from our financial ignorance. Financial advisors get paid a lot of different ways, and some of these ways conflict with making money for you. A broker may be paid a higher commission if they recommend a poor performing fund. Relying on your employer’s default 401k option may not be the wisest investment option. The only person that really cares about your money is you. Paying attention and asking the right questions could mean an additional million dollars in your account by the time you retire.

Investing may seem intimidating, overly complicated, tedious, or even painful. But it’s easier than it may seem, and it can even be fun.

The sooner you get started, the better, but it’s never too late to reap the benefits. It’s worth spending some time learning the basics and taking control of your own retirement.

Principle 2: Compound interest is the 8th wonder of the world.

Here is where the fun comes in. Compound interest can be magical. It can add up significantly over time, so the sooner you get started, the better, but any amount of time is better than none. Because compound interest will compound your accumulated interest, the average return and the length of time the interest compounds matter a lot.

Here are some examples:

1. Example 1: You start saving for retirement when you’re 25 years old. You save $500 per month until you retire at age 63, and you invest your money in the S&P 500 index fund that has an average rate of return of 10%. You’ll have about $2.5M when you retire. Nice.
2. Example 2: You start saving for retirement 5 years later when you’re 30. You save $500 per month until you retire at age 63, and you invest your money in the S&P 500 index fund that has an average rate of return of 10%. You’ll have about $1.5M when you retire. Lesson: the time when you start investing makes a big difference.
3. Example 3: For the same scenario above, all things being equal, if you paid a financial advisor to manage your investments for a 1% fee, you would have about $1M in retirement. Half a million dollars would go to the financial advisor. Lesson: With compound interest, those seemingly small fees can really add up over time and eat into your earnings. Sometimes referred to as the “tyranny of compound interest.”
4. Example 4: You start investing when you’re 30. You save $500 per month until you retire at age 63, and you invest your money in your employer’s default option for your 401k plan. Data shows that the average return for a 401k is around 5%. You’ll have about $500,000 when you retire — $2M less than Example 1. Lesson: the annual rate of return and the length of time the money is invested are the most significant contributing factors to your net worth at retirement. So, start early and invest wisely.
5. Example 5: You start saving for retirement at age 18, and you save $100 per month, every month until you turn 63, investing in an S&P500 index fund, you will have over $1 million when you retire. Lesson: With enough time and a decent annual return, anyone can be a millionaire even when saving small amounts each month.

Principle 3: Invest in Index funds.

You’re ready to get started, but where should you invest your money? There is a simple answer to this question, and it’s called an index fund.

An index fund is a mutual fund that tracks a component of the market and trades automatically based on an index. A traditional managed mutual fund has a human fund manager deciding when to buy and sell. Managed funds tend to have higher fees, which eat into your returns. Data shows that index funds almost always outperform managed funds over the long run.

Why are index funds better than other investments? The short answer is humans are bad at predicting the future, and index funds have low fees. Even the smartest people in the world have a hard time predicting the market’s ups and downs, so an index fund averages an index in the market instead of trying to beat it.

“According to Vanguard, in a study of index funds versus active funds, for the 10-years ending June 30, 2020, a total of 180 of 205 Vanguard funds outperformed their peer-group averages.”

Where can you buy an index fund? An index fund is a type of mutual fund, so most companies that offer mutual funds will have index funds. If you’re saving for retirement via your employer’s 401k program, review the fund options available in the 401k plan. Many will have index fund options. If you have an IRA, your IRA provider will likely have index fund options. Etrade, Vanguard, Fidelity, and Charles Schwab all have retirement accounts with index fund options.

How do you choose an index fund? Not all index funds are created equal, so there are a few things you should pay attention to.

• Choose your index: An index fund that follows the S&P 500 or Total Stock Market Index is a good option. These two funds have similar performance and tend to outperform other indexes.
• Choose a fund with no transaction fee: Some index funds have a transaction fee you pay when buying into the fund, and some do not. Choose a fund without a transaction fee.
• Choose a fund with a low expense ratio: The expense ratio of a fund can vary. The higher the expense ratio, the worse your earnings will be. There are plenty of index funds with expense ratios below .05%, so choose one of these.

Principle 4: Diversification can be simple.

It’s important to diversify to hedge your bets and guard against risk. It’s fun to pick individual stocks, just like playing Roulette can be fun, but it’s a gamble.

There isn’t a ton of consensus on what a well-diversified portfolio looks like, and the market is continually changing, which makes it difficult to follow a set of rules that will stay the same over time. So how do you hedge your bets across a diversified portfolio that will yield the highest return?

The simplest way to diversify is to purchase an index fund such as the S&P 500, which is diversified over 500 large companies, or the Total Stock Market index, which holds 3,550 stocks. Both of these are good options.

Do you need small-cap, mid-cap, bonds, and international investments? The answer is, you can keep things simple. Over the last 10 years, The Total Stock market Index has outperformed small and mid-cap funds, so if you had only invested in the Total Stock market Index, you would have more money today than if you had included small and mid-cap funds. The S&P 500 and Total Stock Market Indexes are diversified enough to mitigate risk.

Should you put some money in bonds? It depends on your retirement age. Markets will go up and down but come back over time, so if the market falls tomorrow, how much money do you need to live on in the short run while you wait for the market to come back? If you need to have money ready to liquidate in the short term, it would probably be good to keep that amount in bonds.

What does the Oracle of Omaha say? Warren Buffet’s advice is to “put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund.”

Principle 5: The market always comes back.

The basic rule of investing is to buy low and sell high. Seems easy enough. But as the market goes up and down, no one knows where the bottom or top is, so it’s impossible to time it perfectly. People who try to predict the ups and downs of the market to buy and sell at the right time tend to lose more than they make. It’s best to buy and hold your investments over the long run.

‘The Signal and the Noise” by Nate Silvers is an excellent book on predictions. Chapter 11 goes into great detail about market predictions. To summarize, we humans are emotional creatures and make poor predictions when it comes to our money. When the market drops, people panic and sell. When the market is up, people get excited and invest more, which results in people having a lot less money in retirement.

“An 1970 investment of $10k in S&P 500 would have yielded $63,000 in profit in 2009, but if one adopted the strategy of pulling money out when the market dropped by 25% and putting it back in when it had recovered to 90% of its earlier price, the profit would only be $18,000. A loss of $45,000.”

There are ups and downs, to be sure, but the market comes back over the long run. If the market crashes, instead of selling all your stock, you may want to consider increasing your 401k contributions while you wait for the market to come back. If you start to feel panicky about all the money you’ve lost while the market is down, take a break from looking at your account balance.

How long does it take for the market to come back after a crash? It’s difficult to predict how long it will take for the market to recover, but even after the worst crises, it’s not as long as you may think. After the Great Depression, it took 3.1 years for the market to recover. After the Great Recession of 2007–08, it took a similar amount of time. After the Coronavirus crash in March 2020, the stock market was back at an all-time high by the end of August, five months later.

Principle 6: Choose a Roth IRA and Roth 401k over the traditional.

Most employer-sponsored retirement savings programs have traditional 401k or Roth 401k options. If you have an individual retirement account, you’ll also have the IRA or Roth IRA options. The Roth version of these accounts will usually result in fewer taxes over your lifetime.

Traditional IRA and 401k contributions are tax-deductible for the year you contribute; withdrawals in retirement are taxed at ordinary income tax rates.

Roth IRA and 401ks provide no tax break for contributions, but earnings and withdrawals are generally tax-free.

Historically, traditional IRAs and 401ks were recommended based on the belief that people in retirement are in a lower tax bracket than when working. The theory was to take the tax break while earning the higher wages and pay the taxes when in retirement. There are flaws in this reasoning.

1. Tax rates change over time, and you may have fewer deductions in retirement which could lead to a higher tax rate. Inflation means the cost of living goes up over time so you’ll spend more in the future for the same lifestyle you have today. It’s difficult to predict what your tax rate will be when you retire and nearly impossible to know for sure that your tax rate will be lower than it is today.
2. A Roth 401k or IRA gives you tax shelter on the earnings in your account which can be far great than your original contribution. This is a point that is most often missed in the traditional vs Roth discussion.

Traditional 401k Example: You invest $100,000 in your 30s with a tax rate of 24%. You put this money in a traditional 401k, which means you save roughly $24,000 in taxes when you make the contribution. Then, you invest this money in the Total Stock Market Index fund with a 10% annual return. Thanks to the beauty of compound interest, your original investment becomes $2.6M when you retire at age 63. You now need to pay taxes on the $2.6M as you withdraw the money. For argument’s sake, let’s say you are in a lower tax bracket in retirement at around 20%. With a traditional 401k, you will pay about $534,888 in taxes when you withdraw your retirement savings.

Roth 401k Example: You invest $100,000 in your 30s with a tax rate of 24%. You put this money in a Roth 401k, which means you pay roughly $24,000 in taxes when you make the contribution. Then, you invest this money in the Total Stock Market Index fund with a 10% annual return. Your original investment becomes $2.6M when you retire at age 63. With a Roth 401k, you pay nothing in taxes as you withdraw money from your $2.6M account, saving you over $500,000 in taxes that you would have paid with the traditional 401k account.

Principle 7: When you change jobs, roll your 401k to an IRA.

If your employee offers a 401k, it’s a good idea to max out your 401k (choosing the Roth 401k option of course). At a minimum, you should always contribute enough to qualify for your employer’s match, so you don’t miss out on this benefit. 401ks offered by employers have higher contribution limits than an IRA, so it’s great to take advantage of these. However, employer-sponsored 401ks usually have fewer investment options and sometimes high hidden fees than an IRA you open yourself.

Whenever you leave a company, you have the option to convert your 401k to an IRA that you manage. There are no tax penalties for this type of rollover as long as you roll the money into a similar type of retirement account: Roth 401k to a Roth IRA. Traditional 401k to a Traditional IRA.

Rolling your 401k to an IRA means more options and better access to low-cost index funds. Lower fees and better performing funds mean more money for you at retirement.

You can open an IRA at hundreds of different financial services companies, but I recommend you find one that has a good selection of index funds to choose from and low transaction costs.

I like Etrade because it offers 7,500 funds from all the big fund managers. If you only want to buy Vanguard funds, you can open an account directly with Vanguard. TD Ameritrade, Charles Schwab, and Fidelity all have index fund options as well.

Other resources to get started

• I love this Freakonomics Podcast with tips on money management and retirement investing: Everything You Always Wanted to Know About Money (But Were Afraid to Ask)
• The Little Book of Common Sense Investing
• This is a great investment calculator: Investment and Retirement Calculator
• If you like John Oliver, he has a funny and educational episode on retirement investing: Retirement Plans: Last Week Tonight with John Oliver (HBO)