Asset allocation is perhaps the single most important investment decision that you will need to make. Fortunately, you only need to make the decision once and then ride it out for the next 30+ years. In fact, changing your asset allocation is far more likely to be harmful than helpful.

So, why is asset allocation important? Generally, when you increase your risk, you also increase your potential for return. That is, if you want to make a higher return, you have to take greater risks. However, if done right, proper asset allocation can achieve both greater return and reduced risk.

When I initially started investing, deciding on my asset allocation was by far the most challenging decision I had to make. In its simplest form, it consists of simply making the decision about how many of your investment dollars will go to bonds and how many to stocks. However, the advice on even that relatively simple decision varies greatly.

Simplifying Asset Allocation

If you are a conservative investor who is willing (and able) to accept a lower return in order to take as little risk as possible, then your age is your bond allocation. Merely subtract your age from 100% and voila, you have your stock allocation. For example, if you are 25 years old, you will invest 25% in bonds and 75% in stock. If you are the risk pursuing type, you can subtract your age from as much as 125%, which translates to 100% stock allocation.

Naturally, if you are in your 30s or 40s and just now starting to invest, you will need to put a larger percentage of your income into investing or take greater risks in order to make up the money you lost by waiting. However, for reasons far outside the scope of this article, you should allocate at least some to bonds because an allocation of up to 10% can actually reduce your risk while also increasing your return. For the same reason, you will always want at least some of your investment dollars in stocks.

As a side note, your stock-bond allocation is the one aspect of your asset allocation that will change over the years. The rule of thumb is that you increase your bond allocation by 1% each year. This can be accomplished in two ways: (1) by putting your new investment dollars into bonds or (2) shifting high performing assets into bonds during annual (or biennial) rebalancing.

Asset Allocation Choices

As I said before, your stock-bond allocation will be your easiest allocation decision. If you decide to go with a total market fund and a total bond market fund, you could theoretically call it quits after making this allocation. However, if you want to continue reducing your risk while increasing your return, you will need to make additional allocation decisions. Here is a list of at least some of those decisions:

• Stocks vs. Bonds
• Growth vs. value stocks
• Government bonds vs. corporate bonds
• U.S. vs. international stocks
• Bonds vs. treasuries vs. t-bills
• Pacific vs. European vs. emerging market stocks
• Investment grade vs. junk
• Large cap vs. mid-cap vs. small cap stocks

Naturally, you can add commodities or other sector specific stocks, as well. However, when you start investing in those areas, you may be venturing out of investment and into speculation.

A great thing about asset allocation is that it can be as simple or as complicated as you want it to be. The best part about it is that asset allocation will allow your investments to ride out many of the ups and downs of the market because, for example, while U.S. stocks are suffering, U.S. bonds are usually flourishing.

In the future, I’ll try to put together some information about your different allocation options. In the meantime, do some research and figure out your stock-bond allocation.

Thanks to Jarrad for the post and make sure to check out his site, Ganbatte Times.

Photo: blprnt

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Adam’s been writing about money for about 6 months. During the podcast we talked about investing as a 20-somethings and the differences between money in the U.S. and the UK.

You can subscribe to the podcast’s RSS feed or download and subscribe on iTunes to get every episode delivered to you.

The Foreigner’s Finances Podcast Episode 9

[01:00] – Adam’s intro to Magical Penny and how got started writing about personal finance

[04:30] – The first steps to getting your finances in order including proving to yourself you can consistently save before you invest

[08:00] – Common misconceptions of investing

[11:00] – Differences in investing between the UK and the U.S.

[16:00] – Adam’s favorite money topics to write about at Magical Penny

[18:30] – What the future of Magical Penny holds

A huge thanks to Adam for taking some time to talk and make sure to check out his site, MagicalPenny.com!

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PT recently wrote a post for U.S. News and Yahoo! called the 5 Reasons Your Are Not Saving Enough for Retirement.

During our conversation we talk about this article and how you can properly prepare yourself for retirement in your 20s and 30s to make your life financially easier down the road. PT also tells us about PT Money’s transformation to a full-time blog and explains what it means to be a marathon completer.

Remember, you can subscribe to the podcast’s RSS feed or download and subscribe on iTunes to get every episode delivered to you.

The Foreigner’s Finances Podcast Episode 8

[01:00] – Welcome and PT Money’s transition to full-time blog

[03:45] – How marathons brought the PT family together

[06:30] – How PT got started with his retirement savings

[08:00] – Using savings tools to make saving/investing easier and automatic

[14:00] – How to give your finances a wake-up call

[18:00] – Saving for retirement vs. your kid’s college tuition

[24:30] – Estimating how much you need for retirement

[29:15] – The downfalls of relying on others for your retirement 

Thanks to PT and make sure to check out PT Money!

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401(k) seems like a scary grown-up word that only stuffy businesspeople who work 65 hours a week and read The Wall Street Journal care about. In reality, there’s a very good chance your eligible to enroll in a 401(k) through your company and they may even offer you free money for investing.

Intrigued? You should be – we’re talking about free money here!

Let’s take a beginner’s look at the 401(k) and see how it can benefit you and your money over the next 50 years.

The Tax Advantage

A 401(k) is an investment vehicle for saving for retirement that provides tax benefits by lowering your taxed income. They are usually organized through your employer to promote retirement savings in your life.

In a Roth IRA your income is taxed first, then invested. The withdraws are tax-free.

A 401(k) works the opposite way. They take your income before it’s taxed, invest it in a fund or stock, and then it’s taxed when you withdraw your contributions in the future. A 401(k) lowers your amount of taxable income and saves you money in the long run because you have more money compounding over decades.

What Do You Invest In?

A 401(k) is just an investment vehicle, not a specific investment – just like a Roth IRA.

The type of investment depends on the employer and can range from different mutual fund options – many different stocks compacted in to one fund – to company stock. There are usually a couple of options that you can choose from depending on your risk, but just know that you won’t be able to choose your own investments for your 401(k).

The Company Match

Currently, only 48% of people invest in a 401(k). What the other 52% don’t realize is that they’re leaving free money on the table.

What sets a these retirement vehicles apart is that many companies offer to match a certain percentage of their employees 401(k) contributions.

Currently, the maximum 401(k) contribution in 2010 is $16,500 and $22,000 if you’re 50 and older.

So, for example, a company may offer a free match on 5% of a contribution. 5% of $16,500 is $825 which means if you invest $825, your company will match you and invest $825 – for free, no questions asked.

Because your money is not taxed until you withdraw, more money can take advantage of compounding now and really grow over time.

How to Get Your 401K Started

Not all companies offer a 401(k), but a good amount do. To get your 401(k) rolling, visit your HR representative at work. When you do, you’ll pick the type of investment and determine the amount of your contributions. After that, your contributions will be automatically deducted from each paycheck and you’ll be automatically investing in your sleep.

If you leave your job, the HR rep can help you roll the 401(k) in to a new retirement account so make sure to speak with them if you plan on changing jobs.

Negatives of the 401(k)

You don’t have many choices when you invest in a 401(k) and your investment may not be used as efficiently as as index fund in a Roth IRA. The 401(k) funds you have available through your employer may have high expenses or invest in areas of the market you’re not interested in.

The 401(k) is a commitment. There are a few exceptions, but your money is tied up in the account until you’re 59 1/2 – unless you pay a 10% penalty. Make sure you plan ahead and can do without the income every year. You don’t want to have to dip in to your 401(k) because you’ll disrupt the compounding and lose out over time.

Regardless, your 401(k) should be your first investment priority if your company offers a free matching contribution. Invest enough to get the match, and then max out your Roth IRA where you’ll have more choices and a more efficient opportunity to grow your money over the decades.

Do you have a 401(k) at your work? Can you share any tips for new investors about the process?

Photo: UrbanData

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“(Company name) sponsors an Employee Stock Purchase Plan whereby all employees are eligible to purchase shares of (company name’s) stock (traded under ticker symbol “(removed”) at a 15% discount off the market price at the end of each calendar quarter. Employee elections, of up to 10% of base salary, are required before the first day of the calendar quarter and are binding for the entire quarter. Employee contributions during the quarter are used to purchase shares at the close of the quarter at 85% of the market price at the time of purchase. Shares are deposited into a personal account with E*Trade Financial on behalf of the employee. All shares purchased through the program must be held for a period of at least six months.”

My friend believes in the world of simple investing through index funds and was wondering if his company’s stock should have a place in his portfolio. I replied that he shouldn’t and let’s look at why I think it’s smart to avoid investing in your company’s stock.

Too Risky

Investing in your company’s stock is a risk. You already have your employment invested in them so if they go under your paycheck and employment is going to go as well. As we’ve seen over the past 2 years, the stability of any job is questionable in a bad economy so going a step further and investing for retirement with a company’s stock isn’t a smart move for negating risk.

Now, my friend’s company makes the offer enticing by offering a 15% discount for the stock. Could this mean they’re desperate for stock holders, or that they’re just being considerate to their employees? It’s arguable, but it’s never a good idea to buy something you’re kind of interested in just because it’s on sale.

See What the Future Holds

15% is a significant discount and one that I suggested could be considered down the road by my friend. Right now, he shouldn’t make the bulk of his retirement savings his company’s stock. He just started the job and doesn’t even know anything about the company so it wouldn’t be a smart move. I suggested my friend keep the offer in the back of his mind. Maybe when he gets some time under his belt at the company, builds up cash savings in an online savings account, and starts investing for retirement in an index fund that he could consider investing some money in his company’s stock.

Warren Buffet once said, “If you don’t feel comfortable owning something for 10 years, then don’t own it for 10 minutes.” My friend doesn’t know much about his future or the company’s so it’s hard to feel comfortable buying stock from them. For the time being, it’s best to avoid his company’s stock and instead take the the easy route of investing with index funds in a Roth IRA.

No One’s Too Safe

Need more reason to avoid your company’s stock? Ask the ex-employees of Enron who had the majority of their retirement savings invested in Enron stock. In all, the workers lost $2 billion in pensions and and share accounts when Enron went under in 2001. They were told their company’s stock was a safe investment and in the end they lost not only their jobs, but their future savings.

So, in conclusion it’s probably not the best idea for your financial future to invest money in your company’s stock. There’s too many unknowns to fully trust putting your money in their company – even with a sizable discount.

What do you think? Should my friend avoid his company’s stock or invest away? Do you invest in your company’s stock?

Photo: Helico

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For those of you who are new to Lending Club, here’s a quick intro on Lending Club and an update from March to catch you up.

Since I’m not able to invest in a Roth IRA while working in Japan, I decided to move a large chunk of my income to Lending Club to fill my investing void while I’m away. I still hold residence in Illinois and pay taxes in America so I’m eligible to invest with Lending Club.

My Returns After 8 Months

If you look at my update from March, I’ve moved more than $8,000 to my Lending Club account since then – up from just $495. This may seem like a lot – and it is – but I can’t invest in a tax-deferred account like a Roth IRA while in Japan so it’s a much better option than having my $8,000 receive $7 a month in interest in an online savings account.

My return has dropped just 1.2% since March, but at that time I had just 20 notes and I now have 265.

Many of my notes are still “In Funding” since I just made a new investment last week so I’m still relatively new to process. Therefore, my interest payments should start to rise pretty rapidly once all of my notes start receiving interest.

Types of Notes

(click to see specifics)

Lending Club allows you to pick your own notes (loans), but this is time consuming and tedious if you have a lot of notes. The easier option is to create a portfolio that is either conservative, moderate, or aggressive. You pick your rate and they find you notes. You can weed out ones you don’t want, but this step is quick and simple for anyone who doesn’t want to be too hands on with the process.

A notes are safer investments, while G notes are risky. As you can see above, a majority of my notes are B through E.

So far I’ve had just 2 late notes (31-120 days late) and are probably going to default. Out of 169 issued notes that are receiving interest, this brings my default rate to 1.18%, which is below Lending Club’s average of 3% since 2007. The great returns make up for the default notes so I’m happy with the results thus far.

My Portfolio Plan

I wish I had an automated investment plan, but my immediate future (2-5 years) is uncertain right now. In the meantime, I’ll make investments as I see fit while also depositing a large percentage of my income to my savings account and emergency fund with Ally Bank.

With Lending Club, notes are either 36 or 60 months, but they allow you to sell notes to other users if needed. I’ve never used this feature, but it’s nice to know the option is available.

Stay tunes, I’ll have another update at the end of the summer.

*Disclaimer*

I’m an affiliate of Lending Club so if you click on a link on this site and sign up for an account with Lending Club, I’ll get a small percentage back. As you can see above, I use and trust this company and wouldn’t suggest it if I didn’t.

If you’d like to open an account today, click on the banner below and see how you can receive a 9% return on your money.

Have you had any experience with Lending Club? Let me hear your thoughts in the comments!

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I recently came across the personal finance site, Oblivious Investor and was amazed by the author’s story. Mike’s in his twenties and used to work as a financial advisor and tax accountant. He now is an accomplished personal finance author with 6 books based around making finance simple.

Since Mike has the background and training in finance, I asked him some questions about investing as a twenty-something. He was kind enough to answer them and tomorrow I’ll be giving away a copy of his book, Investing Made Simple. Come back tomorrow at 9 AM EST to see how you could win Mike’s book.

Here’s the interview:

A: How did you get into writing about personal finance?

M: In the couple years after college, many of my friends were self-employed. At the time, I was working as a tax accountant, so they frequently came to me with tax questions. A little too frequently, actually.

I decided I’d write a short book on the topic of taxes for small business owners. That way, I could just tell them to go buy a copy from Amazon rather than continually asking me questions. It didn’t work. I don’t think any of them bought the book.

What surprised me, however, was that a lot of people (complete strangers!) did buy the book after finding it on Amazon. After just a couple months, I saw that writing could provide a meaningful side income, so I started working on a second book. Since then I’ve written a few more books and started a blog, Oblivious Investor, to help with marketing them. It’s now my full-time job.

A: What’s the book writing process like?

M: There’s lots of outlining to be done at the beginning and lots of editing to be done at the end. But the actual writing is just step-by-step, section-by-section. It’s really not too different from writing blog posts. The key is to not get discouraged at the size of the overall project — just focus on taking it one step at a time.

A: What is your investing advice for an employed twenty-something who has never once thought about money, but wants to get started?

M: First, do some reading. There’s no sense in starting with an investment plan until you know why it’s a good idea to follow that plan. Otherwise, when things go poorly (which will happen from time to time, no matter how good your plan is), you’ll panic and make costly mistakes. You don’t need to be an expert, but you do need to know why you’re doing what you’re doing.

As to the actual specifics, it depends on whether the employer offers a savings plan with a matching program. If there’s a 401(k) match available, enroll in the plan and contribute enough to get the maximum match. If there’s no match to be had, I’d probably suggest starting with a Roth IRA.

As to choosing investments, my suggestion is the same regardless of whether it’s a 401(k) or an IRA:

• Determine an appropriate asset allocation for your goals.
• Look for the lowest-cost funds that will satisfy that allocation.

In most cases, a simple portfolio with just a few low-cost index funds or ETFs is sufficient. Something like:

• A broadly-diversified US stock fund,
• A broadly-diversified international stock fund, and
• A bond fund.

A: Why do so many twenty-somethings avoid investing when the years and compound interest are on their side?

M: Truth be told, most twenty-somethings I know actually did start investing shortly after finishing school. They either enrolled in the 401(k) at their job or opened a Roth IRA on their own. I think our generation is more financially savvy than we get credit for.

Our whole lives we’ve heard stories about the financial mistakes our parents (the Baby Boomers) have made — credit card debt, not saving enough, going all-in on tech stocks in the late 90s, buying huge houses with equally huge mortgages, etc. I think most of us are looking to avoid making the same mistakes.

A: What should the majority of Americans be doing in regards to retirement savings?

M: I’m reluctant to make many suggestions for such a broad, diverse group. About the only things I’d say everybody should be doing are:

• Check your asset allocation to make sure you’re not taking on more risk than you’re comfortable with.
• Look for low-cost funds wherever possible. Expense ratios are excellent predictors of fund performance.
• Make sure you’re saving enough. Don’t assume you can safely withdraw 8% of your portfolio every year during retirement without running out of money.

A: Do you have a day job?

M: Nope. At this point, book sales plus advertising revenue is enough to pay the bills.

A: What’s your goal for Oblivious Investor?

M: Two goals:

1) Provide a counterpoint to the mainstream financial media’s frantic analysis of what’s going on in the stock market each day. For most investors, such short-term movements don’t matter.

2) Make a living while doing something I love — reading and writing about investing and taxation.

A: What do you think about investing in individual stocks?

M: I don’t recommend it in most cases. The investors you’re usually competing against when you buy or sell individual stocks have far more resources than you do. To have a decent chance at reliably outsmarting them, you’d have to be willing to treat it like a full-time job. And even then, success is far from certain.

A: What’s your next book?

M: Retirement Planning Made Simple. As investors get closer to retirement, portfolio management becomes much more tricky. (And mistakes become more costly!) At this point, however, the book is only in the earliest part of the outlining process, so I can’t put a date on when I expect to be finished.

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Thanks to Mike for shedding some light on investing in your twenties.

Make sure to check out his site, Oblivious Investor and remember tomorrow (Saturday) at 9 AM EST I’ll be giving away a copy of Mike’s book, Investing Made Simple.

If you have any questions for Mike about investing, taxes, or writing a book, leave them in the comments and he’ll get back to you.

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Once the interest kicks in it can add a lot to your loan. When you break down the numbers and look at the percentage of your payment going to principal and percentage going to interest, it can be quite disturbing.

Here’s the breakdown of how much each payment goes to interest vs. principal in the first 6 months of a $10,000 loan at 7%:

About half of each payment is going straight to the lender in interest payments and barely making a dent on the loan’s balance.

Seeing these numbers may persuade you to increase your loan payments in order to pay less interest over time. But how do you figure out how much extra you should pay towards your loan every month?

Here’s a guide to help you decide how much extra you can afford to pay towards your student loan every month.

First, organize your loans by the size of the interest rates. Open a spreadsheet and list all of your loans, the principal, the minimum payment, and start with the highest interest rate on top. Anything over 5% is a priority for accelerating payments.

Find out how much each loan will cost you in interest. Use this student loan calculator and plug in the specifics of your loans. How much will each loan cost you in interest if you just pay the minimum? Write this number down in your spreadsheet.

The cost of a loan is misleading. A $5,000 loan at 6.8% with $50 monthly payments ends up costing $6,904 – with $1,904 in interest.

Mark your loans as high, medium, or low priority. High priority loans will be anything above 7% because at this point you’re better off throwing extra payments at your loans instead of investing. Paying off a loan gives you a guaranteed return on your money where as short-term investing is dangerous.

Medium loans are anywhere from 3-7%. Investing will trump paying extra on these loans because their rates aren’t devastating. Eventually when your high priority loans are paid off, you’ll start paying extra on your medium loans because you’ll end up paying thousands and thousands in interest if you just pay the minimum for the loan.

The low priority loans are below 3% and you’ll only pay the minimum on these unless you stumble into a large sum of money. These are your favorite loans because they’ll cost you very little in interest and you’ll be able to set up automatic payments and forget about them.

Before you pay extra on any high priority loans (>7%):

1. Have an emergency fund in place. If you live on your own, this should cover 3-6 months of living expenses. You can’t risk losing your job and having no savings so make sure you have a sizable rainy-day fund insuring your job. If you live at home, you can get away with having significantly less in your emergency fund and paying off your loans earlier will be easier.

2. Invest enough in your 401k to get the company match. If your employer offers a 401k with a company match, you need to take advantage of it. This is free money and shouldn’t be avoided, even if you are carrying high interest loans. You’re young so starting your 401k off now is beneficial for compound interest.

3. Look at your income and see how much you can afford to pay every month. Even an extra $50-100 a month will speed up the process and save you tons on interest in the end. If you hate loans, you may want to put as much as $250 extra towards your loan payments. If you’re content with your loans, then $50 extra is sufficient and will allow you to build up your savings else where.

Before you pay extra on your medium priority loans (3-7%):

1. Have an emergency fund

2. Max out matching 401k contributions at work (free money)

3. Max out your Roth IRA. The 2010 tax year allows you to invest up to $5,000 in a Roth IRA. This is money you won’t be taxed on when you withdraw in retirement, so max this out before you start paying off any medium priority loans because the market historically returns 7-8% (although this is never guaranteed). Starting your Roth now will allow it to grow exponentially faster when you’re older and you’ll be glad you started your Roth at 25 instead of paying an extra $75 towards your loans.

You can invest up to $5,000 but you can also invest any amount lower than that. You have until April 15th, 2011 to invest in a Roth for the 2010 tax year.

4. When the above 3 are complete, pay an extra $50-100 on your medium loans (3-7%). Start with the highest interest rate and work your way down.

Before you pay extra on your low priority loans (less than 3%):

1. Have an emergency fund

2. Max out 401k to get the company match

3. Max our your Roth IRA

4. Start building up specific savings goals (car, house, grad school, baby, etc.). The twenties are an expensive time in your life with a lot of huge purchases. Having extra cash around in your savings account will be beneficial. Open up a sub-savings account at your online bank to help save for specific goals.

5. When the above 4 are complete, pay an extra $50 a month for your low priority loans. At this point, you’ll be financially steady and you’ll end up savings yourself some extra cash by paying down these loans as well.

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Although student loans are an annoying burden that we all want to get rid of immediately, it’s important to take care of other areas of your financial life first.

Here’s a student loan calculator that allows you to see how much extra payments will help your debt situation. You can also figure out credit card debt within the same calculator.

Debt affects people differently so your priorities might be different from my suggestions above. But accelerated payments if you have the funds will save you tons on interest in the end. Run the numbers and get a system going for knocking out your student loans earlier so interest doesn’t dominate your life for the next fifteen years.

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Investing your money isn’t easy. There are tons of high-pressure decisions to be made and the amount of information you have to sort through to find the quality stuff is near impossible sometimes. Despite this, it’s important to push through the difficulties in order to help out your future self in retirement.

There are a variety of systems, techniques, and choices that make investing less complicated. One of these techniques is called dollar-cost averaging which makes the most of your investing dollars and negates the risk of investing, all without having to kill yourself with numbers and analysis.

Let’s take a closer look at why you should consider dollar-cost averaging for your retirement savings.

The Goal of Dollar-Cost Averaging

The biggest fear of any investor is plopping down $5,000 at the start of the year in a Roth IRA and seeing the market crumble the next day. Dollar-cost averaging makes sure this doesn’t happen by splitting up that $5,000 into smaller investments, say 10 investments of $500 each, over a certain interval of time, maybe 6 months or a year.

This techniques allows the daily ups and downs of the market to have less of an effect on your investment. The end goal is achieving maximum value for each investing dollar.

When the market is doing well, it’s not a good time to buy so you’ll purchase less shares. When the market is doing poorly, it’s a good time to buy, so your money will buy more shares.

Dollar-cost averaging is simple because it does away with our irrational minds worrying  ”when should I invest?” Once you have a system set up, you make the purchases monthly, bi-weekly, etc. and move on. You don’t have to watch the market from day to day and you won’t get burned by a big market swing or a decision made on emotion instead of numbers.

An Example of Dollar-Cost Averaging

We’ll use the numbers from above. You want to invest $5,000 in a Roth IRA with a Vanguard index fund starting in January and ending in December.

Once a month on the 1st you will buy $416 worth of stock. You can actually set up your investing account to automatically make this purchase and you won’t even have to remember the purchase every month.

It doesn’t depend on the price of the fund, you will make a purchase on the 1st of the month for $416 worth of stock. Say the fund is $32 in January for your first purchase; your first purchase will buy you 13 shares.

The next month you also buy $416 worth of stock – regardless of the price. This time the stock went down to $25 so you bought 16.64 shares. This continues for the rest of the year until you max out in December at $5,000.

When the market is down and in your favor, you’ll buy more shares. When the market is higher and not a buyer’s market, you’ll purchase less shares but keep your investment moving forward.

Who Should Use Dollar-Cost?

In order to maximize your return on investment, it’s best to purchase a lump sum of stock at one-time. This makes the most of compound interest, dividends, and any large market gains. But for those who are a little more conservative with their investments, dollar-cost averaging is helpful.

If your questioning how useful dollar-cost averaging is, put yourself in the shoes of people who made lump sum investments on October 6, 2008. This was the Monday of Black Week which saw the Dow lose almost 18% in the following 5 days. A $10,000 investment on Monday was worth just $8,200 on Friday – a loss of $1,800!

You won’t make as much as possible with dollar-cost averaging, but you’ll stay away from huge losses that devastate your future and investing morale.

Dollar-cost averaging is also helpful for beginning investors or people who don’t have a lump sum to invest. You can base your dollar-cost investing schedule on your paychecks and the cash you have available per month. Using this system, you can guarantee you’ll get the best value for each individual dollar you invest.

Photo: David Paul Ohmer

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Last week the Dow Jones had a its quickest collapse ever at 1,000 points and a rough day overall dropping 348. Due to the trouble in Greece, political unrest in Thailand and the Icelandic volcanic the markets have been a little rocky lately.

But these reasons don’t really matter and could just be weak attempts to define a ultra complicated stock market full of swings, crashes and runs.

If you’re a passive investor – which 99.7% of people should be – then these crazy swings that periodically happen don’t matter that much. The market will go down, up and sideways but as long as you continually put money into the market every year and gradually get more conservative as you get closer to retirement, then you’ll be alright.

Learning From Those Before Us

During the market collapse of 2008 the Dow plunged 30-40% and every magazine and newspaper posted an article written about people in their 50s, 60s or 70s who were a week away from retirement, but lost 40% of their savings and were unable to retire. They were 1 month away from a new life they had always dreamed about, but back to work they went for who knows how long. These articles often had a picture of the distraught couple on a pier somewhere, half-hugging and looking concerned.

What many of these articles failed to mention was that all of these people had too much of their savings at risk at that point in their lives. When you’re close to retirement (within 5 years) a high percentage of your net worth should be in conservative investments like bonds. When you’re 25, less than 5% of your net worth should be in bonds.

The market’s gone up over time, but the short-term waves of the market are impossible to predict. And by short term, this means anything 5-10 years. So if you have 90% of your net worth in stocks when you’re 65, you’re risking a lot if a market crashes – like it did in 2008.

So why don’t market swings matter?

Well, they do. But the extent that the media covers these swings makes them seem worse than they are – if you’re a passive investor investing in index funds – funds that invest in the entire market and attempt to capture the market’s average.

This is why  Target Date Retirement Funds like those at Vanguard or Schwab are so brilliant. They automatically change your savings allocation (the percentage of money in bonds, stocks, etc.) as you get closer to retirement. A lot of people assume they’ll pay more attention to their money when they get older, but why risk it? You’re life will get more complex with a mortgage, job, and kids and having your retirement savings taken care of at a young age is a smart choice for a lot of people.

When you’re young, risk is ok because you have a lot of time before you retire. The swings don’t hurt you as much as they do for a 65 year-old. Every year invest as much as possible (if it’s an IRA, up to $5,000) and let the fund do the work. When you’re 60, a large percentage of your money will be in safe investments and the swings won’t be life-shattering on your savings.

Yes, stock market swings hurt. I’ve been investing for almost 2 years and I still check the market everyday and I still grimace when the market falls 3% one day and my IRA falls $400. But these swings are normal and I’m already slowly getting used to the fact that this insecurity is how the market works. It takes some time though so if you’re frantically checking your IRA the 1st year you invest, you’re fine, and will hopefully get over it.

But do not let these stock market swings and the media blood bath persuade you to not invest and save for retirement. The worst decision is not starting because you lose the benefits of compound interest. Instead, ignore the unpredictable swings and set your money on the right path for life.

How do you handle stock market swings?

Photo: GeekSystem and Vanguard

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