In my January 5 post, I wrote about big developments shaping retirement in 2011. In this and an upcoming post, we’ll look at simple retirement planning tactics individual investors may want to consider.
1. Savings rates. There’s a widespread myth that you can somehow reach a secure retirement by tinkering with your portfolio. Portfolio management is important, of course, but it’s priority number 2 or 3. Above all, the key to financial security in retirement is adequate savings.
There’s no magic involved in boosting your savings. Increase the amount you’re contributing to a 401(k) or other workplace plan. (To make it painless, raise your savings rate over time—every January, for example, or on your birthday.) If you’re fortunate enough to have reached the plan’s maximum contribution limit, set up a disciplined automatic investment plan into a mutual fund, brokerage, or other savings/investment account. Whatever your approach, don’t just expect to save the money that’s “left over” at the end of the month, quarter, or year. It typically won’t be there. Most of us have to put savings away in a formal way.
The flip side of saving is managing spending (consumption). There’s no way around it. To save more, you have to spend less, so this certainly means understanding—and then limiting—expenses. Controlling expenses is one of the essential elements in building retirement security, although it rarely gets the attention it deserves. (In our culture, the term “saving” usually means getting a good deal on the price for a consumer good, rather than saving/investing in the financial sense.)
2. Portfolio risk levels. Vanguard crew members (our in-house term for “employees”) face a perennial challenge at parties and other social gatherings. The moment you mention you work at Vanguard, you’re inevitably asked, “What’s a good mutual fund?”
(Lately, you’re also likely to be asked your opinion of the emerging markets, gold, or bonds. There are a lot of people out there who mistakenly believe they should invest based on headline returns—a portfolio error if there ever was one.)
The problem with asking “What’s a good mutual fund?” is that it’s like looking at your portfolio upside down. Or, rather, it’s “bottom up” thinking—looking at your assets piece by piece, fund by fund. This sort of piecemeal approach can lead to poorly diversified portfolios, along with the bias of chasing performance.
A better way to approach your portfolio is strategically, or from the top down: How are your savings allocated among different asset classes with varying risk exposures? So, when someone asks me about a hot fund, I respond: “What’s your portfolio risk level today? How are you diversified? What direction are you trying to move in?” It comes down to a question of asset allocation (the way your portfolio is allocated between stocks, bonds, cash, and other assets, such as real estate).
I hope the questioner can give me specific percentages regarding his or her current financial position. Yet it’s surprising to me how few investors know their risk allocation. Many of my fellow party guests don’t seem to know. They’re surprised to discover that, in order to think about which new fund to buy, you need to consider the entire picture—what you own today in total and what your aggregate risk exposure is. Unfortunately, many investors start upside down, asking which new fund to buy.
As my Vanguard colleague Catherine Gordon puts it, some investors have a “collection” of investments—not a portfolio. The former is built bottom-up; the latter, top-down. For 2011, resolve to spend more time thinking top-down. Tools such as Vanguard’s risk questionnaire can help.
Notes: All investments are subject to risk. Investments in bond funds are subject to interest rate, credit, and inflation risk. Diversification does not ensure a profit or protect against a loss in a declining market.