How to Save…How to Invest…and How Much is Enough

In my last column, we touched on one of investors’ most vital questions: How much is enough?

There is no single correct answer. But you should take into account your age, your dependents, your life expectancy and how much it takes to finance your chosen lifestyle.

If you’re new to investing, you can use a financial calculator to determine exactly how much you’ll need to save and invest, over what period of time, and at what rate of return.

For example, if starting at age 25 you invested $190 a month (with dividends reinvested) in an S&P 500 index fund – and earned nothing more or less than the market’s long-term average annual return of 10% – it would turn into $1.02 million by the time you turned 65.

According to the U.S. Census Bureau, the median household income is $59,039.

So it would require the average household to save just 4% of its income – or less than 5% post-tax – to hit the seven-figure mark in 40 years.

Even if a household could only save $95 a month, it would still turn into a half-million dollars in 40 years. That would provide a substantial measure of financial independence, especially if you paid down your home mortgage over the period as well.

Of course, most Investment U readers are (ahem) somewhat older than 25. So your calculation might show that you must save more, work longer and/or earn a higher rate of return.

Others have the opposite problem. They have worked and saved and invested for years, perhaps decades. Now they’re wondering if they’re finally there, if their nest egg is finally big enough.

Well, wonder no longer. It is when you’ve acquired enough assets to provide for your living expenses for the rest of your life.

Here’s how to know that. Take a few minutes to add up your basic annual expenses – including the taxes you’ll owe on required and voluntary withdrawals from your retirement accounts and on the income and capital gains in your taxable assets.

Then subtract your Social Security and (if you’re one of the lucky few) pension checks. This leaves you with your residual living expenses (or RLE).

If you require $70,000 a year to pay all your expenses – and if your Social Security and pension (or other) income amounts to $30,000 a year – you must come up with an RLE of $40,000.

To stay on the safe side, you want to have, at the very least, 25 years of RLE saved up to retire at 60, 20 years of RLE saved up to retire at 65, and 15 years of RLE to retire at 70 – or, in this case, $1 million, $800,000 and $600,000, respectively.

Some, of course, will insist that even a million dollars is not enough to provide financial security in today’s world. This is particularly true for conservative investors.

One million dollars invested in 10-year U.S. Treasury bonds at the current yield of 2.3% would generate annual income of just $23,000 – or less than $2,000 a month. And that’s before taxes.

Sure, you could dip into principal and sell a few bonds. But that would make next year’s income even less.

So a significant portion of your portfolio must be invested in riskier assets, i.e., stocks.

The problem, of course, is that stocks sometimes behave badly. The Great Recession provided a good example of this, although there have been periods when the market did far worse.

That’s why I recommend that smart retirees set aside five years’ worth of living expenses. Here’s why…

The average bear market in the U.S. lasts 15 months. The average decline is 32%. And the average time to recover to the old high is another 2.1 years.

So the average round trip from the beginning of the down market to full recovery is approximately 3 1/2 years. Sometimes, however, stocks take longer to recover. So let’s be conservative and set aside enough money for a five-year round trip from peak… to trough… to the next peak.

When the market is at or near new highs – as it is now – you would liquidate stocks (not bonds or cash) to pay your expenses and fund those extra years of reserves.

But when we’re in a bear market, rather than cashing in your stocks at low prices, you pay your expenses out of your five-year reserve.

If the market keeps going down the next year – and the year after – you continue to live off that shrinking reserve and refrain from cashing in your stocks at bear market prices.

When the stock market finally recovers to new highs, you then cash in enough equities to restock your five-year reserve.

This is a workable, real-world solution to the perennial question of how much to keep in stocks.

But given that these potential actions affect major lifestyle decisions – like how long you’ll work and how much you can spend – it pays to give full consideration to that perennial question: How much is enough?

In my next column, I’ll share various views on this important subject.

Good investing,

Alex

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Source: Investment U