Financial Briefs – Volatility is Not Risk

Financial Briefs are a new section here at retirement is possible. They are short posts, generally only 500-600 words, covering a very specific topic. The idea is that you can quickly see a bit of news, find out how to solve a problem, or get a new insight. Let me know what you’d like to see in future Finance Brief posts. To see more Finance Brief posts check out the Finance Briefs Index.

 

One thing you commonly hear when it comes to the stock market is how risky it is. You hear this a lot when the market is going down. Even sometimes when it’s not. You also hear that it’s like gambling. The market can appear to be risky, but that doesn’t mean that it is. The stock market has gone up and down as long as it has existed. Keep in mind that stock trading has existed since before the United States existed. And in all that time the markets have gone up and down. But just because it goes up and down doesn’t mean that it is risky.

 

The stock market in general isn’t risky It’s volatile. Volatile means that it goes up and down. So in the short term the market will add and lose value. Sometimes a lot, and sometimes in a short period of time. But over the long term the stock market in general works its way up. That’s because the day to day market price is based on short term information. The long term price is based on the foundational health of the long term economy. In the long term the global economy is strong because we produce countless goods and services and rely on those for our continued existence. This means that even when we have a bad year we will still eat. We will still buy things. We will still need transportation. So eventually the market will recognize that and correct.

 

Now, this is about the market as a whole. Individual stocks may be riskier since the strength of an individual company is rarely stronger than the global economy. So how do you maintain the safety inherent in the global economy? Buy lots and lots of stocks in different companies and industries. How do we do that? The simplest way, especially for new investors, is to buy into a mutual fund. I recommend an S&P 500 index fund since it will give you the stability of owning stock in 500 of the strongest companies in the US. It will occasionally go down in value. But in the long term it will go back up. That’s because the market as a whole is volatile not risky.

 

So what is risk? Risk is the chance you’ll lose money permanently. Diversification and research are the two best ways to get around risk. Diversify by buying stocks in several companies. Or better yet buy mutual funds so that you can effectively buy stocks in hundreds of companies. Second, do your research. Buy into companies that are not only making money, but also have a solid plan for maintaining it. A company like Procter and Gamble owns several multibillion dollar brands covering household products that people use every day. That is something very difficult for another company to take from them. It makes good money and has a pretty good plan to make more. A company like P&G continued to make money during the 2008 recession, but the stock price went down. Since the company was still making great money the stock price eventually went back up to reflect that.

 

In short, risk is the chance you’ll lose your money. Volatility is how much the stock price moves up and down. If you buy solid companies then ultimately the value will be maintained and the price will go up. Even though at times the price will go down.

Financial Briefs – Pay Yourself First.

Finance Briefs are a new section here at retirement is possible. They are short posts, generally only 500-600 words, covering a very specific topic. The idea is that you can quickly see a bit of news, find out how to solve a problem, or get a new insight. Let me know what you’d like to see in future Finance Brief posts. To see more Finance Brief posts check out the Finance Briefs Index.

 

The single biggest reason that people don’t save is that once they spend their money there is nothing left over to save. You get your paycheck. You pay rent. You pay the utilities. You buy your groceries. By the end of the month there is nothing left in your account to save or invest. This is a very common problem with a surprisingly simple yet sometimes scary solution. Pay yourself first.

 

This may sounds scary since you know that at the end of the month you are out of money. So in theory this sounds like an impossible task. But it’s not. Look at it this way. Before you even get your paycheck taxes are taken out. Social Security, income tax, yadda, yadda, yadda. They’re all taken out before you even see your money. That’s because the government and your employer learned long before you were born that if the money comes out of your paycheck before you get it then you won’t have much of a problem paying your taxes each year. That’s because we get used to living off of the money we receive. For the most part we figure it out.

 

This is also why you hear about people making millions of dollars then going broke. They got used to spending all of their money when they saw it so they didn’t have any left to pay taxes or loans. This concept works both ways. We as consumers figure out how to spend all the money we make, but we also figure out how to only spend the money we make. Assuming of course you don’t take out debt. If you’ve been reading this site for any length of time you know that I consider debt a bad thing for most people most of the time.

 

So what do we do? First, pay yourself first. When you get your paycheck put some of it into a savings account. Start off with just a little bit so that you can get used to having less to spend. You’ll notice that after a few months you don’t even really notice those few dollars missing. After you do that put a little more in savings. Keep raising the amount you put into savings each paycheck until you are saving enough to reach your goals.

 

Sometimes it’s tough to put the money into savings ourselves. Especially when you already have bills that need to be paid. In this case you can do one of two things. You can have your bank automatically pull money out to go to savings whenever you get your paycheck. Talk to your bank about setting up the automatic draft. The other option is to have your employer deposit a part of your paycheck into a separate savings account. Many companies can set this up for you. Just ask your HR department.

 

The point is that if you pay yourself first then you will be able to save money. You also will get used to living on slightly less money. Start off with a small amount at first. The first time I did this I only put 5 dollars away. That’s all I felt I could afford. But it was a starting point to saving even more.

 

What kinds of things do you do to help you save more or to make it easier to save?

Financial Briefs – The Problem With Retirement Calculators.

Finance Briefs are a new section here at retirement is possible. They are short posts, generally only 500-600 words, covering a very specific topic. The idea is that you can quickly see a bit of news, find out how to solve a problem, or get a new insight. Let me know what you’d like to see in future Finance Brief posts. To see more Finance Brief posts check out the Finance Briefs Index.

 

The Problem With Retirement Calculators.

 

Understanding how much money you need and how much you’ll have to meet your retirement needs are the hardest parts of retirement planning. Retirement calculators are a great way to estimate those needs. There are a lot of very good retirement calculators out there. Two of my favorite are Vanguard’s Retirement Income Calculator and FIRECalc.

 

Retirement calculators are a great place to start, but they can be very misleading. Especially as you gain a stronger financial base. You may need more or less than what they estimate. And you may have more or less when your retire than they estimate. Here are some considerations when doing your planning.

 

Replacement.

How much will you realistically need? Most people only need 50%-80% of their preretirement income. Many people need far less. Some with health issues may need more. As you get older that percent may change as well.

Your house.

If you own a home then you may have your house paid off when you retire. This can greatly reduce how much you need. You can also sell your house and move to a smaller home when you retire. This will reduce the amount of money you need in retirement and may add a bit to your savings account.

Pensions and Social Security.

Most calculators don’t take these into account, or they may not do it in a way that works for your situation. Social Security can be a large part of your retirement account. Check out my post The True Value of Social Security. Use the Social Security Administrations calculator to estimate what you’ll get.

New expenses.

Retirement may mean new expenses like travel and increased medical bills. Consider the roll of medical insurance and Medicare in your retirement funding needs.

Return in the market.

This can vary a lot. Even long term rates can be different. Retirement calculators use rates between 5% and 12% to estimate growth of your portfolio. They both can be real, but won’t match your unique situation. Use a calculator that runs several scenarios. FIRECalc does this. Many others do. A Monte Carlo simulation is one type. A Monte Carlo simulation doesn’t perfectly simulate the market, but it gives you a general idea of the range of possibilities.

Inflation.

Inflation is an unknown. Many calculators assume about 3% inflation. Depending on how you estimate the inflation rate the real inflation could be closer to 4.5% over the decades of your retirement.

 

What to do about all this?

This just scratches the surface. Look at your situation. Use a retirement calculator that allows you to make adjustments to the assumed numbers. Then check several different calculators. You’ll start to see trends. If you compare that to something like the 4% rule then you’ll be able to get a general idea on how much you’ll need to save. Finally, be conservative. It’s better to overestimate a bit. But don’t over do it. Estimating a range based on each of these factors can give you a better idea of what you really need to have and how much you’ll actually spend.

 

What are some other problems with retirement calculators? How do you adapt to them?