You can make a lot of mistakes in your youth … and assuming none of them get you killed or put in prison, you can generally recover from them. Time is on your side. But the closer you get to retirement, the less room for error you have.
As your nest egg gets larger, investing mistakes cost you a lot more. Think about it. If you lose 30% on a $10,000 portfolio, you’re out $3,000. That might be a single after-tax paycheck when you’re young. But imagine losing 30% on a $1 million portfolio. That’s $300,000. For most Americans, that represents years of income in the prime earnings years of your career.
Investing mistakes like that might make the difference between a comfortable retirement and working until the grave.
Today, we’re going to look at five potential retirement mistakes that can dramatically affect your lifestyle. Some will be more relevant to younger investors and others to older investors. But all can potentially torpedo your retirement.
Retirement Mistakes: Waiting Too Late to Start
If you save aggressively in your 20s, you have 40 or more years for those gains to compound. You can save at a more moderate level and let the capital markets do the heavy lifting for you. But the later you start, the harder it gets.
The best illustration of this I have ever seen is Richard Russell’s essay, Rich Man, Poor Man. Russell, who until his passing last year had covered the financial markets since 1958, gives an example of two savers. One opens an IRA at age 19 and sets aside $2,000 per year until the age of 25 and then stops. He invests for just seven years and then sits back and lets it compound.
A second saver starts saving at age 26, one year later than when our first investor stopped. He saves $2,000 per year until age 65, a period of 40 years.
So, we have one saver that started early and quit … and one that started just seven years later, but proceeded to save for 33 additional years. At age 65, who had a larger IRA?
Shockingly, the early investor. Assuming annual returns of 10%, Russell found that the early starter had a net worth of $930,641 by age 65 vs. $893,704 for the late starter.
Naturally, tinkering with the returns assumption will make a difference here. The stock market returns roughly 10% per year over the long-term, but returns vary wildly from year-to-year. But Russell’s point was simple enough: Start early when time is on your side.
If you’re already in your 30s, 40s or even older, you can’t undo your savings decisions from the past. But you can start now.
Retirement Mistakes: Not Saving Enough
A closely related retirement mistake is simply not saving enough. Maybe you’re one of those disciplined savers that lives below your means and salts away a good chunk of your paycheck every month. If you are, then congratulations. You are the sort of person your friends and family should aspire to be.
And I’m not being sarcastic here. At the risk of sounding puritanical, the ability to delay gratification is a virtue. It’s what separates man from the animals. And perhaps more practically, saving allows for the accumulation and pooling of capital. Without capital, big projects are impossible. The ships that settled America, the railroads that expanded it westward and the homes, offices and other buildings we use today all required large pools of savings to finance.
Alas, most Americans are not disciplined savers. Today, the savings rate is just shy of 6%, which isn’t terrible. But that’s roughly half the level of the 1960s … and just ten years ago, the savings rate was pathetically less than 2%. You cannot benefit from the compounding magic of the capital markets unless you have savings.
If you’re already in or near retirement, there is not a lot you can do on this front. But if you’re young, get a roommate, cancel your cable bill, eat at home, drink cheaper beer … do whatever it takes to give the compounding train moving. None of the rest of this matters unless you start saving. And as a good rule of thumb, try to save at least 10% of your pre-tax earnings.
Retirement Mistakes: Not Being Tax Efficient
Not being tax efficient with your investing is one of the worst retirement mistakes you can make. Every dollar that goes to Uncle Sam or to your state tax authorities is a dollar you could have potentially saved and invested. And remember, those dollars are a lot more valuable earlier in your career due to the effects of compounding.
But being tax efficient isn’t hard. Ironically, the best tools to beat Uncle Sam at the tax game actually come from Uncle Sam.
If you are employed and your employer offers a 401(k) plan, get enrolled. Now. As in, stop reading this article and don’t come back to it until you’ve successfully enrolled.
Income you use to fund your 401(k) contributions isn’t taxed. More accurately, the taxes are deferred, but there’s no sense in splitting hairs. In my book, taxes deferred for decades are taxes effectively avoided.
Let’s play with the numbers a little. If you’re in the 25% tax bracket, then you can effectively save 25% more than you otherwise would have been able to due to the tax break. (There are a lot of factors that go into your after-tax pay, and the math isn’t quite that simple. But it’s close enough to serve as a rule of thumb.) So rather than save $5,000 per year, you can save around $6,250. Think that extra $1,250 per year won’t compound over time?
Of course, another nice attribute of 401(k) plans is that they often include an employer match. If your employer is chipping in another 3% to 5% per year, you can really turbocharge your retirement savings.
If you need your funds in a pinch, you can often borrow against your 401(k) plan or, in the worst-case scenario, pay the 10% penalty and the back taxes and raid it.
It’s best not to get into a situation like that. But don’t let fear of taxes or penalties stop you from taking advantage of the single best savings vehicle for the vast majority of Americans.
Retirement Mistakes: Being Too Conservative
One of the biggest retirement mistakes I see is simply having too little allocated to risk investments. And I was very careful in my choice of words when I said “risk investments,” rather than “stocks.” For most Americans most of the time, stocks are the best long-term growth vehicle. If you believe in the long-term growth potential of American capitalism, then having a piece of the action via an investment in the stock market makes sense.
That said, I prefer to cast the net a little wider. I would lump in investment real estate, commodities and other assets as well. There are plenty of times when stocks might not make the most sense, no matter what your age or risk profile. For example, the stock market was wildly overvalued in the late 1990s and stocks riskier than usual based on that overvaluation.
Regardless, you need a little risk in your portfolio, or you are very unlikely to generate the returns you need to fund your retirement. Cash still yields effectively nothing, and risk-free government bonds across most of the yield curve offer a yield that is lower than the inflation rate. So bond investors are actually losing money when accounting for inflation.
As a general rule, you should have the vast majority of your portfolio allocated to risk assets including, but not necessarily limited to, stocks when you are in your 20s, 30s and even 40s. As you get closer to retirement, you should scale down the risk a little, but you probably don’t want to eliminate it altogether.
As I said before, a “risk-free” portfolio in cash and government bonds will not keep pace with inflation. So retirees that are too conservative will see their standard of living recede a little with each passing year.
Retirement Mistakes: Being Too Aggressive
Being too conservative, particularly early in your retirement planning, will potentially kill your retirement dreams. But being too aggressive, particularly late in your career, can be even worse. One of the worst retirement mistakes I see — and I see it more today than ever — is for Americans close to retirement to try and compensate for a lack of savings and low yields on safer investments by taking more risk.
They see that their savings are not adequate, so they start taking excessive risk in an attempt to catch up. It’s a little like a gambler who, after a string of bad luck, borrows money from the mob and puts it all on black in the believe that his luck is “due” to improve.
The results can be devastating. Think back to my first example in the introduction. If you lose 30% on a $10,000 portfolio, it’s not going to have much of an impact on your life or retirement goals. But if you lose 30% on a million-dollar portfolio, you may have to dramatically scale back your retirement plans.
The old rule of thumb was that your exposure to stocks should roughly equal 100 minus your age. So, if you are 60, you should have around 40% invested in stocks. This rule of thumb is evolving as Americans live longer, and I’ve seen variations that use 120 instead of 100. The point is not to pick an exact number though. Rules of thumb are guides, not iron-clad laws of the universe. But the insight is that, as you get closer to retirement, you should have less of your wealth in investments that depend on capital gains and more in investments with more stable values that generate income.
I take a fairly liberal view here. With bond yields as low as they are, I would consider it reasonable to branch out into more exotic investments, such as rental properties or even private placements. But if you go that route, make sure you understand what you are buying and that you’re not simply substituting one excessive risk for another.
Charles Sizemore is the principal of Sizemore Capital Management, a registered investment adviser based in Dallas, Texas.