Building for retirement early enables you to increase the chances of your future prosperity. The longer you have to accumulate assets and build your net wealth, the better. While there are many fine stocks out there, I believe there is no such thing as “buy and hold forever”. As investors, we need to constantly reevaluate our portfolios-- semi annually at the very least. Throughout this article I will explain how I am building my portfolio, what sectors I think have long term sustainability, and finally-- how to allocate your assets depending on your position in life.
Hierarchy of Building for Retirement
- 401(k) (up to employer match)
- IRA (up to contribution limit)
- Diversified Brokerage Account
1) If you are lucky enough to have a job in this tough economic environment, then you this first part is for you. Many companies provide their employees with a 401(k) retirement plan. Some employers will even provide their employees with a match benefit. This means that the employer will match a certain percentage of the employee’s contributions. This is a tremendous advantage to the employees as they gain a positive return on their investments before enduring any market risk.
Another advantage of using a 401(k) is that your contributions are deducted from your taxable income. So if you made $50,000 dollars in a year and contributed $3,000, your taxable income would only be $47,000. Another advantage is that your money is able to grow at a tax deferred basis. So let’s say that you contribute $1 to your 401(k). Your employer is kind enough to match your $1-- let’s say 25%. Now you have $1.25 to invest as opposed to losing 28%(or whatever your current tax rate is) of that to the government. This allows your investment to grow at a much faster rate. However, you will still need to pay taxes on the distributions when you are ready to take your money out of the plan.
It is my opinion that investors should only contribute up to the amount that their employer is willing to match. For 2012, the maximum amount that you are able to contribute is $17,000. If you are over 50 you can contribute an extra $5,500 for a total of $22,550. The reasoning behind this is that your investment choices inside a 401(k) plan are normally limited as compared to an IRA, which can hold many different types of investments.
2) This brings us to the second place that we should look to invest: Individual Retirement Accounts. These act in very similar ways to 401(k) plans. However, when we have the opportunity to pick our own investments there are several factors that we have to examine. Mainly, how you allocate your assets between stocks, bonds, and cash. The rule of thumb is that you want to hold more stocks when you are younger and more bonds as you age.
We also have to look at the differences between Traditional IRA plans and Roth IRA plans. This breakdown has been done a thousand times before, and as I am not trying to reinvent the wheel here, this is a great breakdown of the differences between the two types of IRA’s. For 2012 the maximum contribution is $5,000 with the ability to add $1,000 if you are over the age of 50. If you aren’t lucky enough to have a 401(k), you should definitely try to contribute to an IRA.
One suggestion I have when it comes to IRA contributions is the schedule at which they are done. Many people forget about their IRAs until the last minute and then contribute $5,000. A more strategic way would be to dollar cost average your way into the market by making equal contributions every month. If you’re an active investor, you may consider doubling up on a contribution after the market has taken a drop -- of say, 7% or more. You are effectively buying during the dips in the market and remaining neutral as prices are rising.
This is the point of the discussion where we need to differentiate between active and passive investors. An active investor is one who has time and dedication to research his own individual investment choices (i.e. the stocks of companies). Passive investors, on the other hand, don’t have the time or the drive to do the research. This means that they should focus more on index funds, Mutual Funds, and ETFs. This will give them the diversification that is necessary without having to analyze many different companies.
3) The final place that investors should look to store their money for retirement is in an individual brokerage account. The same active / passive rules apply to a brokerage account. This should be the last step for investing, and most likely will not be used except by those earning too much to use an IRA (over $105,000 for an individual and $169,000 for those filing jointly). If you chose to actively manage this portfolio with individual stocks, I would suggest no more than 10 choices. Otherwise you will not have enough time to perform the due diligence. I would also suggest that the portfolio should be diversified across the different sectors of the economy. It has long been said that diversification is the only “free lunch” out there. I completely agree with this maxim and purpose that any well constructed portfolio should be fully diversified.
Sectors & Choices
Outlook on the Market
The holiday season is upon us, and the fears of the dreaded double dip recession have subsided since the summer. The economic data and earnings reports out of the U.S. have been increasingly promising. However, this good news has been tempered by the continued fall out of the European sovereign debt indices into extremely range based areas.
Many analysts have been proposing for a while that our markets will experience a “Santa Claus” rally into the end of the year. However, with European leaders failing to instill confidence in their latest summit, the rally has not materialized. The markets do seem very cheap to me right now, with some very attractive valuation metrics. However, with Europe’s stubborn refusal to come up with any concrete plan, my outlook for the market is not that bright. It seems that we are in a perpetual struggle between the improving U.S. economy and the mess that is Europe. This leads me to look towards strong, safe dividend producing companies. Some places to start looking are the healthcare, utilities, fast food, and tobacco industries.