Use This Formula to Figure Out How to Invest Your Money at Every Age
If you’ve made the decision to invest your money, that’s great news. Putting your money to work — letting it grow and compound over time — is ultimately what will help you build lasting wealth and retire rich.
In terms of how to invest your money, that depends on things like when you want to retire, your money goals and your risk tolerance. Below, I’m going to introduce you to a formula that will help you figure out how to invest based on your age, but let’s back up first to make sure we understand one key component of successful investing: diversification. Regardless your age or time horizon, you want a well-diversified portfolio.
What is portfolio diversification?
Diversification is when you spread your money around different asset classes (think: stocks, bond, cash, etc.). It’s a strategy that helps protect you from market volatility.
Think about it: If your portfolio consists of a bunch of different asset classes, chances are you’ll always have some that are performing well that can help offset the ones that aren’t performing well at any given time. But if you were only invested in one asset category, say stocks, and stock prices tanked, your portfolio would experience tremendous losses.
It’s always important to have a diverse portfolio, but it’s especially important during times of uncertainty like right now amid the Covid-19 pandemic.
The way you divide your portfolio among different asset categories is known in the investment industry as asset allocation. Asset allocation is just a fancy way of saying, “You need to put your eggs in different baskets.”
The first step in determining the right asset allocation for you is to divide how much of your money you want to put into growth vehicles (stocks and stock-based mutual funds) and how much you want to put into safer but slower-growing fixed-income securities (bonds or bonds funds).
How much should you invest in stocks vs. bonds?
Stocks (also known as equities) and bonds are two of the most common classes of assets. Stock represents ownership. When you buy stocks, you’re buying a very small portion of a company. With bonds, there’s no ownership: Instead, you’re lending money to a company or government. Then, the company or government will pay you interest on the loan over the life of the bond. And, at the end of the term (what’s called the “maturity date”), the principal is returned.
Investing in stocks is considered riskier than investing in bonds (because there’s no guaranteed return when you invest in stocks), but with higher risk can come higher reward: The stock market has historically returned an average of 10% annually, while the bond market has a 10-year total return of about 4%.
It’s smart to invest in both, especially because they tend to have an inverse relationship — meaning, when stock prices go up, bond prices tend to go down. As for how much of each to invest in, I use this formula:
Take your age and subtract it from 110. The number you get is the percentage of your assets that you should put in stocks or stock-based mutual funds. The rest of your assets should go into something safer and less volatile, such as bonds, other fixed-rate securities or cash.
For example, let’s say you’re 40 years old. Following the rule, you subtract 40 from 110, which leaves you with 70. That means you should consider putting about 70% of your retirement fund into stock-related investments, with the remaining 30% going into bonds or other fixed-rate securities.
If that seems like a lot of money to put into stock-related investments, remember that you want to invest for growth. Many people make the crucial mistake of thinking that when it comes to their retirement money, the thing to do is play it safe. When you’re close to retirement or already retired, you can play it safer — but until then, you need to go for growth to ensure you beat inflation.
Obviously, the older you are, the smaller your stock investment will be. According to the rule, a 50-year-old should have 60% of his or her assets in stocks, while a 30-year-old should have 80%. This makes sense, since the closer you are to retirement age, the less risk you want to incur.
Now that you understand how much of your money should be invested in stocks vs. bonds, review your retirement plan and see if it matches what you just found using this formula. If it doesn’t, you may want to rebalance your portfolio.
If you are at all unsure about what the best available investment options may be for you, seek professional guidance. Speak with your company’s benefits director or call your financial advisor and ask him or her to go over your retirement-plan options with you.