Now comes the fun stuff, bringing your investment objective to life. By now, you've determined your financial goals, timeline, and tolerance for risk. These are all prerequisites for establishing an investment plan.
In the US, most companies establish a 401(k) for their employees. This is a standard retirement plan in which employees can contribute a portion of their paycheck to allow an investment firm chosen by their employer to manage their money. The employer also has an option to match employee contributions to their 401(k).
However, investments are extremely limited under 401(k) rules, and you have no control over the fees attached to managing your money, even if your returns are low due to market events or poor judgment. This is why self-directed investing is an attractive option for individuals who want greater control over their investments, and the potential for higher return over time.
Individual retirement accounts (IRAs) come in two forms: Traditional and Roth. A traditional IRA allows you to contribute pre-tax dollars, which means your money grows tax-deferred, and your withdrawals are taxed as income after you reach age 59.5. So, this could make sense if you expect to be in the same or lower tax bracket at retirement.
A Roth IRA allows you to make after-tax contributions, which means your money grows tax-free, and you can generally withdraw without taxes taken out after age 59.5. For both traditional and Roth, there's a $6,000 annual max contribution, and $7,000 max contribution for those ages 50+.
For younger listeners, a Roth IRA could make sense as you'll have many more years to earn more and potentially enter a higher tax bracket. At that stage in life, you'd want to keep more of what you earned instead of giving it away in taxes.
Roth IRAs also have a 5-year holding period from the time of your initial contribution. This means that you can't and shouldn't use a Roth as a short-term investment portfolio. For listeners outside of the US, pensions, and superannuations are the norm, so check with your plan administrator on specifics.
Once you decide on the appropriate plan, think about what level of return you'll need. Generally, over the next 10 years, you can expect the following average annual returns:
- 5-7% for US large-cap stocks such as Microsoft, Apple, and Amazon
- 7-8% for smaller to mid-sized international companies
- 3% for bonds
Any scheme that promises higher returns will likely require greater risk. We're not trying to time the market. Instead, we're seeking to factor these expected returns into a long-term plan.
A neat trick is to use the rule of 72 to determine how much time you need to double your initial investment. Simply divide 72 by the expected rate of return. So, it should take you about 12 to 14 years to double your investment solely based on the expected returns of large-cap stocks. Now, of course, this can vary based on your portfolio mix and other factors.
Remember, if you need to withdraw your investment in less than three years, you're better off with cash-like products such as CDs, money markets, or short-term bonds.
For three to five years, you'll still need to hold mostly bonds and cash-like investments, along with some stocks. This is because you'll not have much time to recover from potential stock losses.
If your horizon is five to ten years or more, you want to allocate more than half of your portfolio to stocks. And you should diversify geographically. More on this next.