One of the toughest, most important financial decisions you can make is how much to save for your retirement. If you save too little, you can wind up being forced to work until you're physically incapable of doing so, damaging your dreams of comfortable golden years.
If you save too much, on the other hand, you risk missing out on enjoying life along the way and risk having your heirs, rather than yourself, enjoy the fruits of your lifetime of labor and thrift.
Finding the right balance is important, but when all is said and done, you won't really know how well your plan worked until it's too late to make major changes.
Make your choice
With that in mind, your choice is really one of what types of risks you want to take with your time and money. One strategy you can use is to invest as if you were expecting mediocre returns, while still striving to achieve better ones. In effect, what you're doing is hedging your bets and better assuring that you will ultimately wind up OK.
With the market's return over the past decade or so having been less than stellar, it's really tempting to set your return expectations lower. In fact, that may well be the exact right thing to do. Because if you're targeting returns higher than you actually achieve, the end results are far worse than if you target returns lower than you wind up getting. On the flip side, if you target returns below what you actually achieve, you can wind up pleasantly surprised at retirement.
Think of it from the perspective of this admittedly simplified matrix:
If you …
Achieve 5% Returns
Achieve 10% Returns
|Target 5% Returns||You wind up OK.||You can retire earlier or more comfortably than you initially expected.|
|Target 10% Returns||You work until you drop.||You wind up OK.|
The trick, of course, is to invest in a way that you have a chance of reaching those 10% returns. It's fairly easy to lock in 5% or better returns in this market by buying investment-quality bonds, like the ones below:
Bond Maturity Date
Yield to Maturity
|General Electric ||AA+||3/15/2029||36966TBN1||5.06%|
|Bank of America ||A||3/15/2019||060505DB7||5.12%|
|Morgan Stanley ||A||1/25/2021||61747WAF6||5.34%|
|Kraft Foods ||BBB||8/11/2037||50075NAR5||5.73%|
Source: ScotTrade Bond Center. As of March 25.
As long as the companies issuing the bonds don't default and you hold them until they mature, you'll get the promised yield to maturity. But the problem there is that once you lock in your bond returns by buying them, they're locked in for the life of the bond. The only chance you have of seeing a higher return in a fixed coupon bond is if interest rates drop and you can sell that bond prior to maturity for a gain.
You could seek out floating rate bonds and see your coupons rise if interest rates do, but then you also face the risk of seeing your total return drop if rates fall. But instead of buying the bonds those companies offer, why not consider buying their stocks, instead?
The risk/return trade-off
According to standard financial theory, bonds are less risky than stocks because bonds have payment priority. If a company skips or reduces its stock dividend payment, it's "sorry about your luck, shareholders." If, on the other hand, a company skips or reduces its bond payment, the bondholders typically have recourses that range from priority catch-up payments to a total take-over of the company.
The trade-off for that lower risk from bonds is a lower potential return. Or, said differently, if the market is working as expected, the long-run return has the chance of being higher in a company's stock than in its own bond, because those stocks are inherently riskier.
So if you're willing to plan for retirement by investing in investment grade companies' bonds to lock in long-term returns, why not invest in those same company's stocks, instead? If the same dollars, invested in the same companies, earn a higher return, then you can retire earlier or more comfortably. If, instead, all you manage in aggregate is long-run bond-like returns in those stocks, you wind up in the same spot as had you bought the bonds in the first place.
Yes, the risks are higher in stocks, but so are the potential long-run returns.
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At the time of publication, Fool contributor Chuck Saletta owned shares of Microsoft, General Electric, and Bank of America. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.