When it comes to saving and investing to achieve a successful retirement, you will need to make a few main assumptions. Namely, how much you want to save on a regular basis and how much that investment will grow to when you want to retire.
We’ve discussed how important it is to continually increase your savings rate year after year. But how much is your investment going to grow by each year? Savings accounts grow at virtually 0% these days, and the stock market is unpredictable in the short-term - what is a responsible way of making this assumption?
Our best indicator is history. Seemingly every day I hear a new prediction about the direction the market will turn next and have been hearing of a “low-return” environment for the past 5 years (the S&P 500 has since returned an average of 13+% annually over the past 5 years).
What I’m trying to say is, predicting the future direction of the stock market is really really hard. History is our friend. Choose your speed limit based upon your desires.
School Zone - 20% Stocks / 80% Bonds
In the school zone, we drive slowly, so as to avoid any major speed bumps in the road and arrive at our destination in a safe manner. When it comes to investing, you can allocate your portfolio to replicate driving in a school zone.
By keeping 80% of your investment portfolio in bonds, the majority of your money will grow slowly, but consistently. With just 20% of your portfolio in the stock market, you will be able to realize some growth, but the stock market fluctuations will have a smaller impact on your portfolio as a whole.
Historically, a “school zone” type allocation will have a 4% average annualized return. The majority of annual returns can be expected to land somewhere between -0.5% and 8.5%.
The downside of investing in the school zone, is that it’s going to take you longer to reach your destination (retirement). You will then have two options, wait longer for your investments to grow, or save more of your income on a regular basis.
Two-Lane Highway - 60% Stocks / 40% Bonds
On the two-lane highway, you are moving at a good speed, but nothing crazy. You are headed to a specific destination miles away, but taking your time.
The traditional 60/40 portfolio is common practice, and for good reason. It is a moderate allocation focused on long-term growth, with enough of an allocation in bonds to smooth out the ride along the way.
The “two-lane highway” allocation has historically provided a return of about 7%. This allows your portfolio to outpace inflation on your investment journey to retirement. The majority of annual returns can be expected to land somewhere between -3% and 17%.
As you can see, with the additional growth opportunity comes a greater range of possible outcomes.
South Dakota Interstate - 90% Stocks / 10% Bonds
In my home state of South Dakota, the Interstate speed limit is 80 miles per hour. It’s awesome. You can get across the entire state quickly but there are risks involved, especially during a blizzard.
For long-term investors, this is where you want to be on the long road to retirement, if you can stomach the market fluctuations. It’s important to remember that although there may be some pretty big bumps in the road, you will make it to your destination if you keep moving forward.
On the “South Dakota Interstate” allocation, diversified portfolios have historically returned about 9%. You are able to have your invested dollars help get you to your retirement destination quicker than any other road out there. The majority of your annual returns can be expected to land somewhere between -5.5% and 23.5%.
Talk about a range of outcomes. Although there are bigger fluctuations in the short-term, the long-term result is a greater benefit to you. But if you can’t stomach the bumps, it’s better to stay on the slower roads.
Now that you can see that investing can provide a range of different outcomes, you can make a more educated decision of what you need to save on a regular basis, based on which road you prefer to take.
As I mentioned last week, your savings rate is more important than your investment returns. So whichever road you decide to take, be sure to increase your savings on a regular basis, and you will be knocking on the retirement door before you know it.
*historical returns and percentages are not guaranteed and not indicative of future results
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