When preparing for retirement, it is important to understand the money cycle. Most people think there are only two parts to it, when there are really three parts. While you are working, you are in the accumulation phase. You are paying down major debts such as a mortgage and student loans.
You are hopefully saving money in a variety of different accounts such as 401(k) s, brokerage accounts and other investments. You have a pay check coming in on a regular basis, which covers your expenses and savings. You are not consuming these savings because you will need them someday when your paycheck stops.
Many people enter the accumulation phase when they complete school. Sometimes they have been partially in accumulation while still receiving their education. The time frame until retirement may be thirty, forty or more years. Because of this long time frame and the fact that income for living expenses is coming from wages and not savings, people can take on more risk.
History shows that if you have a long enough time frame, the stock market offers the best opportunity for high returns. There can however be big swings in the market. This does not matter while you are accumulating if you have enough time until you need the funds. At the beginning of 2000, it took twelve years to recover an S&P 500 investment. The Japanese stock market has still not recovered from thirty years ago! Still, the US market gives you the best chance for long term growth.
The most important consideration during the accumulation phase is to invest as much as possible and do it regularly. If you invest the same amount every month, sometime you will be buying more shares than in other months. When the market dips, you will be buying more shares. When the market rises, you will get fewer shares. This is known as dollar cost averring. This does not assure you of making a profit, but it usually results in a lower average cost per share.
The last phase is distribution. This is when you retire and your paycheck stops. Most people use to get a pension when they retired. Baby boomers are the first generation where many retirees do not receive one. Most will receive Social Security. These two income sources often leave a short fall of needed retirement income. This must be made up from savings during the accumulation years.
The important phase that many people forget is the “preservation” phase. This should start about five years before you retire and protect the first seven or so years of your retirement. Investments in this time period should be protected from stock market risk. While there never is a good time to experience a market correction, there is a worst time. This is right before or early during retirement.
This is the time sequence of risk can wipe out your portfolio. This risk is the evil twin of dollar cost averaging. You never have time to make up early losses because you are pulling needed income out of your retirement accounts. Sequence of risk is not a problem during accumulation. The only issue then is not saving enough. During distribution early losses can destroy your portfolio. This is why you must remember the “preservation” phase goes in the middle between the other two events. This will give you a more enjoyable retirement.