The fundamental principle in investing is the higher the risk, the higher the reward potential. That’s what makes stocks so appealing to many people. Stocks are one of the riskier investments because there are no guaranteed returns, and there’s always a chance your investment goes to $0. Yet, there is also unlimited return potential with stocks. Just ask investors in Monster Beverage (NASDAQ: MNST). A $10,000 investment in the company in August 1995 would be worth over $44 million as of Aug. 23, 2022.
You should never make an investment expecting that type of once-in-a-generation return, but it also doesn’t require that. Even $10,000 invested into the S&P 500 20 years ago would be worth over $35,000 today. (The S&P 500 tracks the 500 largest public U.S. companies and is often used to gauge the stock market’s health.)
Investing in stocks isn’t just something people do when they have extra money lying around to play with. It’s something people do out of necessity to prepare for retirement. If you’re young (under 40 years old, for the article’s sake), stocks are where your focus needs to be.
Life isn’t much cheaper when you retire
The unfortunate truth is that retirement isn’t cheap, and it’s showing no signs of getting any cheaper anytime soon (if ever). Just look at healthcare, one of the biggest expenses retirees face. According to Fidelity, the average retired couple age 65 in 2022 will need roughly $315,000 saved for health expenses. If you’re a young investor, this doesn’t necessarily mean it’ll be that expensive by the time you retire. But considering that from 1970 to 2020, U.S. healthcare spending went from $74.1 billion to $4.1 trillion, there’s no reason to believe you should prepare for less.
Healthcare is just one part of the equation, too.
Conventional investment wisdom tells us you should plan to have 80% of your pre-retirement annual income in retirement to maintain your current lifestyle. If we follow that rule, here’s how much someone should plan to have annually in retirement:
|Current Annual Income||Annual Income Needed in Retirement||Total Needed for 20 Years|
Data source: Author calculations.
Even if we take a basic approach of “you’ll need $X each year for 20 years,” many people will need well over $1 million saved. And this is on the lower end because you should increase your annual withdrawal to keep up with inflation each year. In addition, many people will live well past 20 years into retirement.
Bonds probably won’t get the job done
To get to the amount you’ll likely need for retirement, strictly saving in a traditional savings account won’t do it. Neither will bonds. Bonds may be safer investments than stocks because the returns are guaranteed (although bond issuers can default on them), but their relatively low returns make them not-so-ideal for younger investors who need to focus on growing their money.
Suppose you invested $10,000 into a 30-year bond with a 4% annual coupon rate (the amount paid in yearly interest). Assuming you reinvested the bi-annual coupon payments, the investment would be worth over $32,800 after 30 years. Compare that to a $10,000 investment into an S&P 500 index fund, where the average long-term annual return is around 10%. After 30 years, $10,000 would be worth over $174,000.
Making any money on an investment is a good thing, but you also have to consider the end goal: living financially secure in retirement. This means putting bonds on the back burner for a while and focusing on stocks until you near retirement.
Adjust with age
Bonds undoubtedly have their place in investing — just not so much when you’re young. For someone younger than 40, it makes sense for your investment portfolio to be in all stocks because stocks give you the highest chance of growing your money. You’re also at the age when bear markets and other down periods in the stock market won’t derail your retirement plans because you will more than likely have time to recover.
As you age and near retirement, you’ll want to begin slowly but surely shifting your focus from growing your money to preserving what you’ve made, and that’s when bonds will serve you best. Until then, enjoy the benefit of time because it’s the greatest tool investors have in creating wealth.