Calculating your retirement needs and risk tolerance

I just started a new job, please help me setup my portfolio!For the majority of people investing in their companies’ 401K plan or similar, few have a clue as to what they are doing or for what reasons.

Rather than asking a neighbor, or your distant cousin – you have decided to take this chore upon yourself. First, let me congratulate you on taking some time to try and understand this sometimes complex task. Now that’s out of the way, let’s move on to making some sense of this mess.

Just like selecting a healthy diet, defining what is healthy or acceptable to you or me may not be true for the other guy. Your diet, like your investment plan, should change over time to accommodate your health (or wealth). Not too many young people care what fast food they stuff in their mouth, but as they get older – those same foods do different things to your body – leaving you no other choice but to eat what your body will allow you. Younger people can afford to be riskier, they have time to correct mistakes as they get older. However, as those kids get older -they must be more careful how risky they are with their money, as they have much less time to make up for mistakes.

Keeping this in mind, allow us to start our first, and potentially most important lesson for the beginning investor- Calculating your retirement needs and understanding your risk tolerance: Basically, the younger you are the riskier you should be, as you get older your investment portfolio should change to protect your newly accumulated wealth and you should move your investments into less risky options. Pretty basic huh? Yes, I would agree – however too many people skip this first step all together and or don’t understand it at all.

Let’s shed some further light on exactly what this means by looking at an example of how two different aged people, starting investing and retirement planning at different times in their lives should go about retirement planning. I’ll take a look at a mother and daughter and compare what their investment strategies should be. The first investor, Mother, just turned 50 years old and has been investing now for about 10 years. The Mother’s daughter, whom just turned 30, has been investing for almost 10 years now too. These two people have very different objectives and goals to achieve from their investments, even though they started at the same time.

When Mother started to dabble in investing – she was 40, and she wanted to retire in about 25 years, and have the ability to support herself for 20 years without working. Mother knows this is a lofty goal but thinks there will surely be increases in life expectancy – so she wants to cover herself for as long as possible. She estimates she will have her home paid off by the time she is 60, and the only other income she will need to support herself will be for living expenses of which she estimates however many dollars per year she will need. She estimates those dollars to be 10,000 per year for 20 years – So, by the time she hits 65 she wants to have $200,000 in savings. Even though Mother could potentially make a bunch of money by investing in riskier stocks, she could potentially lose everything – thus preventing her from doing anything other than selecting a mix in her portfolio that will guarantee the outcome she wants. So, Mother picks mutual funds that guarantee a certain level of return with a certain level of risk.

So, Mother did the following:

  1. She estimated when she could retire based upon when all of her major bills would be paid (cars, homes, credit cards,etc.) off.
  2. She estimated how much money she would need to maintain a comfortable lifestyle for the remainder of her life after retirement.
  3. She then set her investment goals to obtain and protect the amount of money she will need at retirement (We will get into further detail later as to what types of mutual funds would best fit her needs).

Now, her daughter on the other hand has nearly 35 years until she will ever consider the possibility of retiring as she is only 30. Her daughter started investing much earlier than her mother and has very different objectives and goals. Her daughter determined that she will have her house paid off by the time she is 50 and that she wants to live modest now in hopes of a fun life of travel during retirement. Her needs though come at a price, unlike her mother, the daughter will want $50,000 a year for the 25 years she expects to spend in retirement, or $1.25 Million dollars – so she can see all the things her mother didn’t get to and so her children can come along too. Not to mention, her daughter has to plan for her children’s college needs. Since the daughter began investing at such and early age, and has the ability to stay in the market for the long term, she has chosen an option that will make her much more money in the long run – however, it is much riskier. However, the Daughter understands, as she get’s older she will simply change her investment strategies to protect her money as needed.

Let’s summarize the Daughter’s plan:

  1. She calculated when she wanted to retire and how much money she would need to maintain the lifestyle she wants after retirement. She figured out how much money it would take to pay off all of her bills and fund her children’s tuition needs.
  2. She then set out to find a portfolio that matches her age and risk tolerance. She knows, as she accumulates more and more wealth and get’s older and older, she will have to sell off the riskier stocks and bonds for one’s with more certain returns and less risk.

The above Mother and Daughter example shows you how two different people correctly go about gauging their retirement needs and start thinking about their abilities to take on risk. Riskier investments = higher returns, safer investments = lower returns.

This is the extreme basics of retirement planning, we will build upon this knowledge going forward.

In addition, I have a Retirement Calculator that will help you figure out what your needs will be when it comes time to retire.

Please move on to the next lesson at your own pace, but don’t wait too long – or it may cost you! Learn the difference between retirement savings and benefit plans and the different investment types available to different types of workers (government, private companies, individuals not being offered a 401k by their employer, etc.)

Don’t have time to carry on now? Come back at your leisure, but don’t wait too long, every dollar wasted is a dollar not working for you. Also, consider signing up for my daily updates sent right to your in-box. Don’t worry, I hate spammers too.

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