Building a rock-solid retirement portfolio can be easier than you might think. By knowing how much to save and some basic investment principles, you can put yourself in an excellent position to achieve your retirement savings goals and still be able to sleep soundly at night in the meantime.
Figure out how much you'll need to retire comfortably
The first step is figuring out how much you'll need to retire comfortably, and then determine what you'll need to save each year to get there. After all, a retirement portfolio full of smart investments won't help you achieve your goals if you aren't saving enough money.
Here's a thorough discussion of finding your retirement "number", but here's a quick method.
- First, determine how much income you'll need in retirement. You can estimate this as about 80% of your pre-retirement income.
- Next, subtract other sources of income you'll have in retirement, such as Social Security benefits and pensions. You can get a good estimate of your Social Security income by creating an account at ssa.gov and viewing your most recent statement. The result after subtracting is your income need from savings.
- Finally, using the "4% rule" of retirement, which admittedly isn't perfect, multiply this amount by 25 to get a ballpark idea of how much you'll need to save for a comfortable retirement.
How much do you need to save each year?
There is no way to accurately predict the performance of your investments, but historically speaking, a 7% average annual return is reasonable and conservative to expect. With that in mind, here's a calculator that can help you determine the right amount of money to save each year. (NOTE: If you're saving in a retirement account, like an IRA or 401(k), you can use "0%" for your tax bracket.)
Editor's note: The following paragraph is provided by CalcXML, which built the calculator below.
Know your ideal asset allocation
To be perfectly clear, there's not a one-size-fits-all rule for asset allocation. For example, an investor who received a big inheritance and already has enough money to retire could potentially afford to take a little more risk than other investors, or could also afford to leave more money in cash since growth isn't as much of a concern.
Having said that, one great rule of thumb says that if you subtract your age from 110, you can estimate the percent of your retirement savings that should be invested in equities (stocks), with the rest in fixed-income (bonds). For example, I'm 35, so this implies that about 75% of my retirement portfolio should be invested in stocks and 25% in bonds. A 60-year-old investor, on the other hand, would be better off with a 50/50 mix.
The basic idea is that stocks can be quite volatile, but also tend to produce the best returns over long periods of time, making them most appropriate for investors who have sufficient time to ride out the ups and downs. Bonds have more limited long-term return potential, but tend to less volatile in the short run, a good combination for older investors who need to preserve their capital.
Notice that I didn't say anything about cash. I generally encourage investors to put all of their retirement portfolios in stocks and bonds, unless they're already retired. Simply put, cash assets such as CDs and savings accounts barely generate any returns at all, and actually lose purchasing power over time because of inflation. Besides, for investors with extremely low risk tolerance, there are some types of fixed-income investments, such as short-term Treasuries, that are virtually as safe as a savings account and can produce higher returns.
Diversify, diversify, diversify
Once you've gotten your asset allocation down, the next step is to create a diverse investment portfolio. Generally speaking, this means using ETFs or mutual funds to invest, instead of individual stocks and bonds. In fact, billionaire Warren Buffett says that index funds are the best investment for most Americans.
For your stock holdings, a good core holding is a broad index fund, such as the Vanguard S&P 500 ETF (NYSEMKT:VOO), which has a minuscule management fee and invests in all 500 companies in the S&P 500 index. You can also put some of your money into small-cap and mid-cap stock funds, as well as in international stocks. A portfolio of just three or four ETFs can literally have exposure to thousands of stocks. The point is that your portfolio's success or failure won't be too dependent on any one stock.
Check your portfolio regularly, and make appropriate adjustments
Once you've set up your investment allocations, and have chosen a diversified assortment of investments, it's important to evaluate your portfolio periodically, and for a couple of reasons.
First is to gradually adjust your allocation of your new investments as you get older, which is fine to do every few years. Personally, I like to shift my asset allocation every five years, although I may do it more frequently when I get closer to retirement age. For example, when I turn 40, I'll allocate roughly 5% more of my new investments to fixed-income assets. Of course, if you invest in target-date retirement funds, as I discussed earlier, this won't be necessary.
The second major maintenance activity is to re-balance your existing investments, which is almost the same concept, but could be necessary more frequently.
Let's illustrate this with an example. We'll say that you maintain a 75% stock, 25% bond allocation like I do. Now let's say that the stock market rises by 20% this year, but your bond investments don't budge. I'll spare you the mathematics, but the higher value of your stock investments would result in a 78% stock, 22% bond allocation. In this case, it could be a good idea to shift some of your money into your bond investments.
The bottom line is that if you know what you'll need to save, take advantage of the available tax benefits, allocate your portfolio responsibly, diversify your investments, and do a good job of portfolio maintenance, building a retirement portfolio that can stand the test of time can be easier than you think.