Sadly, many people may never achieve financial independence. The 2019 Survey of Consumer Finances showed that the average retirement savings for all American families is $255,130, but the median retirement savings for all families is only $65,000.1 How much someone should save has nothing to do with averages—and everything to do with goals, planned future spending, and preparing for financial independence.
Principle 6: Build a New Three-Legged Stool.
Anyone who has ever read a basic investing book or taken a class on investing will have heard about the importance of diversification. It’s just as important to diversify how funds are saved as it is to diversify how they are invested. Saving to become financially independent should be divided into three categories we call the New Three-Legged Stool:
Leg One: Tax-Deferred Savings
This is money saved pre-tax in a 401(k) or traditional IRA. Saving money in these accounts can have immediate tax benefits, usually in the form of deductibility. They can also provide long-term tax benefits through tax-deferral of the earnings. However, the IRS will tax these savings when the funds are withdrawn from the account.
Leg Two: After-Tax Savings
This is money saved in a bank or brokerage account that has no tax-preferred treatment. Funds are held after-tax, and the earnings are taxed each year as they are realized. The benefit of these accounts is accessibility and preferred tax treatment when the funds are withdrawn. There is no tax penalty to access the money.
Leg Three: Tax-Free Savings
The final leg is the Roth IRA and Roth 401(k). The Roth IRA has become a popular way to expand retirement investing for many investors. Although contributions are not tax-deductible, Roth distributions can be tax-free if certain conditions are met, and the owner is not required to take distributions at age 72.
The goal is to balance savings and investments over all three legs. Take advantage of the tax benefits from an account such as the 401(k) while also putting money in a Roth IRA, which can provide tax benefits in the future. We feel this is the ultimate in tax efficiency. Many people make the mistake of saving only in their tax-deferred account to get the current tax deduction. This may be short-sighted thinking. Every dollar withdrawn from these savings will be subject to income tax in the future. Tax brackets may never be as low as they are today. A one-sided savings plan that relies only on tax-deferred savings could mean paying taxes at a higher rate in the future.
Principle 7: Embrace the volatility of the stock market.
Most people do not like volatility. Volatility is equated to risk, and reducing risk is a crucial investment objective for some. It is common for investors to choose the relative certainty of a 2% return from a certificate of deposit rather than the stock market, where historic returns have averaged around 10–11%.2
Historically, inflation has averaged nearly 3.1%.3 Choosing to invest in a CD does reduce volatility, but it does nothing for the success of the investor’s financial future.
Some investors frequently shift money in and out of the stock market. They get out when a crash is expected and get back in when an upturn is predicted. The problem with trying to time the market is that no one can consistently predict the short-term events that push the market up or down.
Believing in the ability of market timers is the equivalent of believing astrologers can predict the future.Larry Swedroe
Investors may be better served by embracing the volatility of the stock market. It is the volatility that produces the 10–11% average return. If stock prices were stable, the returns might not be as high. Investing professionals call this a “risk premium.” This simply means that if an investor is to put up with the volatility of his or her portfolio, that investor should be rewarded with a higher return (although there are no guarantees). It makes sense.
Principle 8: Diversify and rebalance to succeed.
We believe that a successful long-term investment strategy should be based on broad diversification over the asset classes, with periodic rebalancing to take advantage of market volatility. Allocate assets across the major asset classes—stocks, bonds, and cash—to help pursue the optimal returns for the risk level an investor is willing to undertake. Diversify within each category to take advantage of different investment styles. Invest in a mix of growth and value stocks, as well as various size companies such as large-cap and small cap-stocks.
Rebalance periodically. Market activity can shift the percentages within a portfolio, so diligence is required to keep a portfolio balanced. A common mistake among investors is to sell stocks or stock mutual funds once they have gone down to “avoid” further losses. A better approach may be to buy more stocks after a decline to take advantage of lower prices. For example, let’s assume there are two assets, each representing 50% of a portfolio. If one declines to 45%, the other would become 55% of the portfolio as a result. To maintain a 50% balance in each asset, we would sell 5% of the larger asset to buy more of the asset that declined to 45%. Following this disciplined approach with an investment portfolio forces the investor to sell high and buy low.
- Diversify savings over all three legs: tax-deferred, after-tax, and tax-free accounts.
- Market volatility is the friend of investors, not something to be feared.
- Rebalancing is a disciplined way to take advantage of the ups and downs of the market.
- The Average Retirement Savings by Age and Why You Need More by Alana Benson, Nerdwallet. December 15, 2020
- What Is the Average Annual Return for the S&P 500? Investopedia. Updated February 19, 2020
- Long Term U.S. Inflation. InflationData.com. Updated December 15, 2020
Originally posted August 2012