There are three actions that significantly affect the accrual of supplementarysavings for retirement. First is the amount (percent of salary)going into savings. Second is the length of time that money hasto compound (earn interest on itself). Third is the rate ofreturn that is earned.
Over a working lifetime, the greater portion of the accumulation in a person'ssavings will be interest earned rather than money deposited. The "rule of 72"states that dividing the rate of return into 72 will tell how long it takes for moneyin the account to double. For example, money earning 6% will double in 12 years.Money earning 9% will double in 8 years. The first lesson to beobserved from this is that savings should be started as early as possible. It ismore important to save at a modest rate for a longer period of time than to saveat a higher rate for a few years. The second lesson is to not beoverly conservative in savings allocations among the available investment funds.
The basis for any investment decision centers on the concepts of risk and return.Typically, higher-potential returns involve higher risk. The level of risk a personis willing to take is a personal matter. There are two types of risk that need to beconsidered in making allocation choices: risk of loss, and riskof inflation. Losing invested money is a concern for everyone. As a result,money is often invested conservatively to avoid loss. This brings low earnings andplaces the investor at risk of inflation—not earning enough to offset the effectsof inflation now and into retirement. A better approach is to find a comfortable balancebetween fixed funds--debt instruments that pay a rate of interest over a set period of time(e.g., money markets, short-term bonds, long-term bonds) and variable funds—stocksthat provide ownership in companies.
This balance of allocation choices may be driven by decisions based on timehorizon (length of time before the money will be accessed), risktolerance, and financial objectives. One general rule of thumbis to put one's age in fixed investments. For example, at age 25, a person would have 25%of his/her investments in fixed funds and 75% in variable funds. A second rule of thumb is the"tummy" test. This is driven by a person's risk tolerance. A person's "tummy"will tell them at what risk level they are comfortable. Investment choices to achievevarious financial objectives may be structured as follows.
|Long-term Growth||25% Fixed||75% Variable|
|Growth & Diversification||40% Fixed||60% Variable|
|Safety & Growth||50% Fixed||50% Variable|
|Safety & Diversification||60% Fixed||40% Variable|
|Safety||75% Fixed||25% Variable|