written by: Steve McFarlane•edited by: Jason C. Chavis•updated: 8/29/2010
Here are some basic principles you will need to incorporate into your investment strategy when planning for retirement. These basic principles of investing for retirement help you make the proper choices when it comes to planning.
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Building a good retirement investment strategy is essential if you hope to comfortably cover your living and leisure expenses once you stop working. When building retirement accounts there are about 5 variables you have to work with. They are time, regularly savings/investments, interest rate, risk and inflation. Each of these will help with the basic principles of investing for retirement.
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The Time Value of Money and Compounding
Of all the variables in your investment strategy, time is the most important.Given enough time, small and regular investments can grow into substantial sums even if interest rates remain low over the life of the investment. While it is never too late to start, it is better to start early.Someone who opens a 401k account in their 20’s will have more funds to retire on than someone who starts in their 40’s.
Did you know that a 35 year old who invests just $3700/yr at 10% p.a. would have $1,002,790 at age 65? Money will start to work for the investor as the power of compounding acts on the invested funds and the interest they earn are reinvested year after year.
Starting early may also reduce the tendency to take unnecessary risks.If an investment fails or causes a significant drawdown on the retirement account, a young investor will have more time to start over as opposed to someone who is closer to his or her sunset years. And while young investors can take more risks, they don’t need to, simply because they have more time with which to build a significant nest egg. No need to despair if you didn’t start your account while you were young, the idea is to start as soon as possible.
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Risk, Returns and Diversification
Generally speaking, investments that have the biggest risk carry with them the highest rewards when things go right.It is for that reason that government bonds produce less then half the average returns of stock market investments. For this reason, retirement portfolios must have a good mix of assets that are suited for retirement investing such as mutual funds, bonds, and cash equivalents. But as the investor gets closer to the retirement years his portfolio has to be reshaped to have less funds in the risky asset classes such as stocks and more in Treasuries and cash. It is a hard thing to see a retirement account take a 20 or 30% loss at the time you are ready to retire.For this reason it is important one’s investment strategy become more conservative the closer you get to retirement.
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Staying Ahead of Inflation
It is good and well to make high returns, but the growth of one’s investment means little if it is not staying above of inflation. The inflation rate suggests how much more expensive it is to purchase an average basket of goods in one period when compared to another.
In other words it tells how much the spending power of your money is falling.To ensure that you stay ahead of the game, you will need a return on your investment that is higher than the rate of inflation and sum. In general, a regular savings account will not preserve the spending power of your dollar. Some good investment vehicles include stocks and inflation protected treasuries (TIPs).
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Good financial planning starts with having a vision of what you want to have at some time in the future. Then the next step is to just start, however small, just start.Your investments should include a diversified basket that may include mutual funds, stocks, bonds and real estate property, but as you get closer to retirement you will need to reallocate your funds with a bias against more risky investments such as stocks.Of course you can make it easy by making the maximum contributions to your company's 401k plan, especially if it is well managed. However, it is never a good idea to put all your eggs in one basket, so do consider setting up another IRA.