Source: 401(k) 2012
When investing for retirement, many investors are unsure of what type of stocks to buy. Should income be the primary objective? Do growth stocks have a place in a retirement account? Shouldn't most of your money be in bonds, anyway? There is all kinds of advice to be found regarding retirement accounts, but there are a few really easy principles that can help you know what's good for your account and what's not.
Will it be needed in 100 years?
This is one of the things Warren Buffett likes to say about his portfolio, and he emphasized this point in a recent letter to Berkshire Hathaway's (BRK.A -0.28%) shareholders. This is one of the easiest principles to understand, but far too few investors use this in their portfolio.
Take a look at Berkshire's holdings. They include businesses that sell insurance, food and beverage, clothing, furniture, construction and materials companies, media companies, jewelry stores, and banks. The way they do business will certainly evolve, but it would be tough to make the case that any of these businesses will be obsolete in 100 years.
On the other hand, will people in the year 2114 need the types of products that Apple or Google produces? Maybe, but maybe not. It's impossible to know for sure. Will people still smoke cigarettes in 100 years? Tobacco companies might not be the best long-term investment. However, people are still going to need to insure their possessions, eat dinner, put on clothes, build homes, and will still need banking services.
Ask yourself this question with every stock you consider for your retirement portfolio. It may change the way you look at things.
Stock/Bond mix? Does it matter?
I've heard all kinds of answers to this question, and the most popular is the "age" ratio. This basically tells you to convert your age to a percent and that's how much you should have in bonds. In other words, a 50 year old man should have 50% of his money in bonds. I wholeheartedly disagree with this rule.
You can certainly have most of your money in stocks, but more important than the allocation itself is that you manage risk correctly. It is a common misconception that stocks are inherently risky and that bonds are inherently safe. As long as your holdings are safe and diversified, it is completely fine to add 20-30% to that figure (or 70-80% stocks for a 50 year old).
It's all about dividends, right?
The short answer is yes, but while it is important for the stocks in your retirement portfolio to pay dividends, it's even more important the company has a good track record of increasing shareholder value and raising its dividend. While past performance is not a perfect indicator of future results, it is definitely useful in deciding which companies are most likely to give you a growing income stream over time.
The website dividend.com publishes a list of all stocks that have raised their dividend every year for at least 25 years, and most of the longest-running companies on this list fit the "100-year" criteria mentioned earlier. For example, the stock on the list with the longest streak of dividend raises (60 consecutive years) is Diebold (DBD), which has provided services to the financial industry since 1859. Sure, their products have evolved from safes and vaults to ATMs and electronic security products, but there will always be a need to keep consumers' money safe.
Invest early and invest often
Once you are satisfied the company you want to buy meets the requirements of the 100-year test, and you are confident the company will provide you with a growing income stream for years to come, the best thing you can do is to get started as soon as possible. Time is the most powerful in an investor's arsenal, and it is what allowed Buffett to build his massive fortune.
Albert Einstein once called compounding "the greatest mathematical discovery of all time." Allowing your dividends to compound over time is one of the most certain paths to wealth in the world.
