There's a reason a dollar invested today is worth more than that same dollar in the future. Thanks to the beauty of compounding, the money you invest today can grow into a larger sum over time as long as you choose the right investments. It's this strategy that enables so many Americans to build retirement nest eggs by socking away money and letting it compound year after year.
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But when we talk about returns on investment, we tend to make assumptions. I know I do. Specifically, I tend to use 8% as a target for long-term average annual returns. It's a figure I've inserted numerous times when mapping out savings projections, and it's based on a slightly downward adjustment of the stock market's historical performance.
Now to set the record straight, when it comes to stocks, I still stand by that projection. I truly believe that the right mix of individual stocks or funds can produce an average yearly 8% return over time.
The problem, however, is that not all portfolios are as stock-heavy as others. Many employ a 60% stock/40% bonds allocation. And according to a new study from investment advisory firm Research Affiliates, portfolios with that sort of traditional investment mix can only expect to see a net 4.6% return over the next 10 years.
Now you may be wondering: What's wrong with a 4.6% return? Well, let's put it into perspective. Is it far better than what you'll get from a traditional savings account? Yes. But will it allow you to achieve your retirement savings goals? Possibly not. And there lies the problem.
Will risk-aversion wreck your retirement?
Some investors have a healthy appetite for risk and, as such, load up on stocks. While stocks have historically delivered high returns, they're also far more volatile than bonds. But here's the thing about the stock market: If you're willing to invest for the long haul, you stand a strong chance of coming out ahead. Between 1965 and 2015, the S&P 500 underwent 27 corrections of 10% or more -- but ultimately recovered from each and every one. If you have several decades ahead of you to save, and you're willing to be patient, stocks could be your ticket to the comfortable retirement you're already dreaming about.
Or, to put it another way, if you don't invest in stocks, and you stick to safer investments instead, you risk coming up short when retirement rolls around. The following table shows how your ultimate savings balance might take a hit if you shy away from stocks and limit yourself to less risky investments:
TABLE AND CALCULATIONS BY AUTHOR.
So let's go back to our question: What's wrong with a 4.6% return? Well, in our example here, you'll see that saving $400 a month for 30 years gives us a total of $298,000 with an average 4.6% return, while saving that same amount for 30 years at an average 8% return results in $544,000 -- a $246,000 difference.
Now divide that $246,000 by 20 years, because given today's life expectancies, that's the minimum length of time you should factor in for retirement. Over the course of two decades, that additional sum translates into an extra $1,000 of income per month. That's a life-changer right there.
Step up or save more
If you want a shot at a financially secure retirement, you'll need to make a choice -- go big, or save more. Being aggressive isn't for everyone, but if you're not willing to put most of your money into stocks early on, you'll need to compensate by saving even more.
The following table shows how much you'll need to save each month to achieve a similar ending balance based on a moderate 4.6% return versus a more aggressive 8% return:
TABLE AND CALCULATIONS BY AUTHOR.
As you can see, that 8% return allows you to save about half as much money while enjoying virtually the same ultimate benefit. In other words, if you're not willing to invest aggressively but want to retire with close to $750,000, you'll need to save $1,000 a month over 30 years to achieve that goal. But if you're willing to go stock-heavy, you can get away with saving just a little more than half as much.
Of course, if you've been employing a more moderate investment strategy all along, this isn't to say that you should just toss it out the window. At the end of the day, you're in the best position to judge your appetite for risk. Just be realistic about the sort of return it's likely to generate, and fund your savings accordingly.
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