James was having a discussion with a friend of his regarding the stock market and investing for your retirement. James and I are of the same opinion that although you can’t time the tops and bottoms of the market, there are technical indicators that give you clues when to get in and when to get out. His friend believes in the age old theory that buy and hold for the long term will outpace most other strategies out there. Ultimately James friend told him that many of his friends with MBA’s and degrees in finance told him this was the right strategy. James friend doesn’t believe you can time the market and that is why you just stay in it no matter what. Let the power of dollar cost averaging and compounding interest do the work.
So who’s right? Well, it really depends on several factors. There are several questions you have to ask yourself before you should just choose a retirement plan off the shelf. How old are you today and what age do you want to retire? What will be your main source of income when you hit retirement? What is your current financial situation today? What do you expect your financial situation to be in the future? These are just a few questions to ask yourself and you need to research this area significantly to ensure you are choosing the right path. You don’t want to get within a few years of retirement only to find out you are never going to hit your mark.
Here are some of the pros and cons I came up with to James’s friend’s approach to his retirement plan:
- You don’t need to spend any time managing your account
- You are going to take advantage of dollar cost averaging and compounding interest
- You maximize your tax benefit today
- You are establishing a good habit of saving your money instead of spending it
- You have a plan
- Negative returns on your account take longer time to recoup and your account will be subjected to them
- You can’t take true advantage of the markets ups and downs and the ultimate power of dollar cost averaging
- You may not be able to retire at the age you wanted
- You may pay more in taxes in the future
- You may not be able to withdraw these funds until 59 ½ without penalty.
In fairness to James’ friend I did some research on the fund that he invests his 401(k) money into and used Morningstar to see what type of return you would get if you had started investing in that fund prior to the crash of 2007. It wasn’t that bad with an average return over 9 years of 10%. In other words, if you invested $10,000 into the account in 2006, today your money would be worth just over $18,000. That doesn’t seem to be a bad return and it looks like the fund will do quite well over the long term. This fund is what’s called a Target Date Fund or TDF. TDF’s are designed to do the work for you in that you choose the date you want to retire and the fund will invest your funds accordingly. In this case it is 2050, so the fund will invest your money aggressively in the beginning and begin to scale back to more conservative investments as you near 2050. There are several factors you need to consider if you are taking advantage of these types of investment vehicles. First, you need to ensure the fund performs exactly as advertised. According to Morningstar, the top 20 (by size) 2010 TDF’s were still heavily invested in stocks in 2008. If you were using this strategy and you were two years from retirement, the average performance of these funds was a negative 26.74% and over 50% of the total account was invested in stocks. This can have a devastating effect on your account and you are only two years from retirement. Many will tell you to just work longer; however, if you are in your late 50’s or early 60’s, you can’t afford to take the risks with your money as you could when you were in your 30’s. Unfortunately, the only way to recoup your losses quickly is by investing in riskier assets such as stocks.
Many folks today are enjoying the ups and downs of the stock market. I certainly did back in the 90’s. Unfortunately, when you are only 10 to 15 years from your retirement date, a major crash will have a devastating effect on your account. Many will tell you that these losses will be recouped when the market corrects itself, and they are right. However, your plan requires consistent positive returns, year after year. The time it will take to recoup your balances are lost years of investing power. In other words, if it takes four years to get back to break even, you may have to add four years or more to working. Furthermore, don’t forget that if the TDF you are invested in starts transferring money to safer assets, you have less money earning bigger returns that stocks can give you in a healthy market, thus adding to your time.
So, back to the original question, who’s right? Millions of Americans nearing retirement in 2010 that had large 401(k) balances as their primary source of wealth going into retirement will tell you James is right. That strategy had dire consequences and many had to continue working. Conversely, there were others that fared well because they retired well before the crash of 2007, so they didn’t see a drop because most of their money was in safer investments. To me, that sounds like you are betting that your “timing” in the market is correct. If your 401(k) is going to be your primary source of income for retirement, I don’t feel you can afford to take that approach. It’s not a matter of working a little longer; it’s a matter of being forced to change course when you are coming in for a landing. With a little financial education, you can prevent this scenario from happening to you and hopefully take advantage of market trends..
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