Retirement planning is filled with conflicting advice. This leads to both fear and confusion for current retirees and those approaching retirement. Questions arise, such as “How should I set up my assets to grow now and in the future?
In a constantly evolving investment landscape, how is the retiree to know what to do? Given changing interest rates and the multiyear run-up in stock prices, here are a few retirement strategies to avoid right now.
1. Avoid holding a long-term bond fund.
My father-in-law called me in a panic last month and inquired why the balance on his bond fund was falling. After all, for many years, the balance on his fund had gone up every month. I explained that as market interest rates rise, all bond fund values decline. Long-term bond funds fall further in value than short-term funds with an interest rate increase.
We sold his long-term bond fund at that point and transferred the proceeds into a certificate of deposit which can be rolled over within the next few years as interest rates rise. A better alternative to a long-term bond fund today is a short-term bond fund, government I (inflation) bonds or a certificate of deposit. With these options, you won’t risk losing principal value as interest rates increase during the next few years.
2. Avoid skipping the workplace retirement plan.
If your employer offers to match your contributions into its retirement 401(k) or 403(b) plan, you must contribute a certain amount to capture the match. Choosing not to participate is throwing “free” money away. If you make $5,000 per month and the employer matches your contributions to the retirement plan up to 5 percent or $250, you should do it.
Look at it this way: If you participate in the plan and receive the extra $250 per month, that’s an additional $3,000 per year. Invest the employer’s and your own contribution of $250 per month, and that adds up to $6,000 per year. Direct those funds into a diversified index mutual fund earning an average of 7 percent per year and after 40 years, those contributions are worth $1,320,062. To make over $1 million, you only contributed $120,000.
3. Avoid putting a lump sum into the stock market right now.
The stock market (or Standard & Poor’s 500 index) has a price tag, called the price-earnings ratio. This is the aggregate market price of stocks divided by the aggregate earnings of the stocks. When the PE ratio is relatively high, stocks are relatively expensive. When the PE ratio is relatively low, stocks are cheap. In general, stocks selling at a relatively high PE ratio appreciate in value much less in the coming years than those selling at a relatively low PE ratio.
According to Global Financial Data, the average market PE ratio from 1871 to 2013 is 15.99. The current market PE ratio is 18.72. When compared with the historical PE, today’s price is on the frothy side. This doesn’t mean that the stock market won’t go any higher. It may. But if history is any guide, over the next several years, it’s likely to revert to its mean PE ratio and either decline in value or advance much less rapidly.
If you’re fortunate to have a large sum to invest, don’t put it all in the stock market right now. Invest it in equal amounts over the next few years to avoid the possibility of going all in at the highest valuation.
4. Do not put too much of your cash in dividend stocks and stock mutual funds.
Some people feel like the only place for their funds is in dividend stocks or stock mutual funds since they’ve been on a nice run-up over the past few years. Do not avoid holding cash. By holding cash in a savings account, money market fund or bank certificate of deposit, you may not be getting much of a return, but with inflation at a low, you’re also not losing much purchasing power either. Several large mutual fund managers are increasing their cash positions due to the higher valuations in the stock market. If you have some cash in your portfolio now and the stock market declines in value over the next few years, you’ll have some cash available to go back in at a lower valuation.
Cash also gives the retiree or soon-to-be retiree peace of mind. You can watch your investment portfolio go up and down and not worry that if an unforeseen expense crops up, you’ll be forced to sell at an inopportune time.
Avoid these retirement pitfalls and sleep better at night knowing your financial portfolio is prepared for the present and the future.
Barbara Friedberg, MBA, MS is a portfolio manager, consultant, website CEO and author of “How to Get Rich; Wealth Building Guide for the Financially Illiterate.” Learn more about investing at Barbara Friedberg Personal Finance.