Whether you are saving for a car, a new home, or are planning for retirement, it’s important to understand how to create a balanced strategy to build your savings. Investments are the best way to get your money to grow over time, but you still need to have an investment time horizon to establish goals for the return on your money.
You can count on a savings account, money market account, a certificate of deposit (CD), or even a fixed-rate individual retirement account (IRA) to yield a steady return. While the earnings from compound interest are steady, the annual percentage yield is modest, typically close to just 1%.
Investments, on the other hand, are higher risk but also yield higher returns. For example, the stock market historically yields an average annual return of 10%.
To make the most of your money, you want to blend a guaranteed return from fixed interest assets and take advantage of the higher potential returns from investments. You also want to establish a time frame to meet your financial goals.
Assessing Risk and Return
An investment time horizon is the time needed to hold an investment until you expect to get your money back. Time horizons are dictated by the types of investments you make and the investment goals you set.
For example, you may be saving for college tuition and want to set an investment goal of 5-10 years. Perhaps you are saving for a down payment on a home, and your investment time horizon is 2-3 years. Or you may be planning for retirement, and your investment time horizon is 30-40 years.
When establishing an investment time horizon, you also want to consider the types of investments that will help you achieve your goal. Asset allocation is how you divide your money between different types of investments such as stocks, bonds, mutual funds, and cash.
Diversifying your investments is the best way to manage risk. Depending on your financial goals and your taste for risk, you can weight your investment portfolio toward riskier stocks or safer investments. Most people become more conservative with their money as they approach retirement age and adjust their asset allocation over time.
Determining How Much You Need
No matter what your financial goals are, you need to have a financial plan. What is your target amount? If you are saving for a home, then you should have an idea of what you need to save to make a down payment. If you are saving for retirement, then set a financial goal that will allow you to live comfortably when you retire.
When establishing financial goals, you also want to set your time horizon. For example, perhaps you want to retire at age 55. You need to have a plan to get there. If you want to reach a specific financial goal in five years, then that’s a short-term investment horizon. If you are saving for tuition or a new home and want to reach your goal in 10 years, then you have a medium-term installment horizon. Ten to 20 years or longer is a long-term investment horizon.
Let’s use retirement to illustrate how investment horizons and asset allocation work together. When planning for retirement, you must first determine how much income you want or need when you retire. That will determine how large of a nest egg you need to maintain your income in later years. Many financial advisors apply the 4% rule, which states you should be prepared to withdraw 4% of your savings every year of your retirement. The 4% rule also assumes your asset allocation is 60% stocks and 40% bonds. If you change that ratio, the outcome will differ.
A more accurate formula to emerge from the 4% rule is the 25x rule. The 25x rule states that you will need to save 25 times your estimated annual expenses. If you expect your annual expenses to be $50,000, then you need to save $1.25 million by retirement age. There are some flaws in the 25x calculation since it assumes a 30-year retirement plan, and you still need to account for inflation and changes to your cost of living.
Once you establish the size of your retirement fund, you can set some investment goals, including an investment time horizon.
Balancing Time and Assets
As you plan your investments, remember that different assets will mature at different rates. Savings products such as CDs have fixed interest rates and preset maturity dates, so the return on investment is more predictable. Investments such as stocks, bonds, and mutual funds fluctuate, so when you’ll achieve your investment time horizon is less predictable.
To achieve your financial goals, you need to map your projected earnings against the investment time horizon. You should adjust your asset allocation regularly to try to align the calculated returns with your financial goals. Younger investors generally have less cash available and more time to invest, so they tend to embrace riskier investments in anticipation of higher returns. As your wealth accumulates, you can move earnings into safer investments.
The investment advisors at iQ Credit Union can help you navigate the complexities of investing. Having an expert to guide you makes it easier to set realistic investment goals and allocate assets to meet those goals.
If you want to review strategies to meet your financial goals, contact the iQ Investment and Retirement Services Center. You also can get started by learning more about investing with our guide, Retirement Strategies: Building a Successful and Secure Retirement.