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Start a retirement plan (Level II to financial freedom)

Once you have completed Level I (Tackling Bad Debts) in the Financial Freedom game, you will proceed to Level II: Retirement Planning. There is a lot to consider when successfully setting up your retirement plan. At this level, we will only cover the accumulation portion of your retirement planning, not the distribution phase (which occurs when you retire). To set up your retirement plan, start with the Top Three Factors: Determine your goals, the number of years until retirement, and your tolerance for risk. The goal of this initial process is to establish the average sliding path of how contributions and appreciation will add up to enough money for you to convert to income upon retirement.

When I opened a retirement account, it was 1998 and I think Roth IRAs had just been set up. So, I went through the whole process with a financial advisor, who was also my neighbor. I wanted to retire when I was 65, I wanted $ 3 million, and I had a high tolerance for risk. He had always assumed that a high level of risk was required for any possibility of a great reward. I don’t think like that anymore! When the dot-com bubble burst in 2000, I had a new feeling about my “high risk tolerance.” After paying all the brokerage fees, I think I lost about 50% of my investment that year. Because of that loss, I was forced to reevaluate what it meant to have a high-risk tolerance. Since then, I’ve learned that you don’t need to take high risk to get good, consistent returns. In fact, it’s probably best not to.

Many people don’t seem to get satisfactory answers to the point of those 3 planning questions. So, I will say that the main point of identifying your goal, time horizon, and risk tolerance is to establish your portfolio’s asset allocation. Your asset allocation is the combination of various asset classes (such as stocks, bonds, and real estate) that you will target, in percentage terms. Higher risk tolerances allow for higher volatility. Since stocks are more volatile than real estate and bonds, a higher tolerance for risk would create a portfolio with a higher percentage of stocks. Lower risk tolerances seek to reduce volatility and therefore target more fixed income in asset allocation.

How does asset allocation work? It works in two ways. One way is diversification. Because asset classes react differently to the changing environment, diversification, over time, produces better results with less volatility. Why is that? All investments are affected by 4 main factors:

1) prices of raw materials as prices of inputs, specifically oil,

2) interest rates as cost of borrowing,

3) inflation (or deflation) as a combination of federal policy, monetary policy and general prices, and finally,

4) the economy, in terms of growth (business and economic).

Investments are affected by the nominal figures of each of these 4 factors, as well as by the exchange rate. For example, you may have low interest rates, but if those interest rates start to rise rapidly, then the market will begin to discount that change. The exchange rate can greatly affect market volatility and prices. Remember, the end goal is for the market to be a future discount to earnings, and any big change in any of these four areas will greatly affect the calculation.

The second way that asset allocation works is through “rebalancing.” Rebalancing allows for a systematic process of buying low and selling high. Rebalancing your assets at set points throughout the year, say twice a year, allows you to sell asset classes that have grown more than their target allocation percentage and buy asset classes that have deviated below their allocation of target assets. This provides a process that automatically and consistently buys low and sells high.

Now why are we talking about this in Level II: Retirement Settings? It’s because I recommend that you find a service that can do all of this for you as cheaply as possible. I recommend looking at the “robo-advisors”: WealthFront, Betterment or Personal Capital. These companies walk you through the planning questions, set a risk tolerance number from 1.0 to 10.0, and then set up an asset mix based on your profile. They allow you to set up automatic contributions and will handle rebalancing on a set schedule. The important thing is to have all of this within an automated system so that you don’t even have to think about it. You can also buy index ETFs directly, with no trading fee, from a brokerage such as TDAmeritrade. They offer 100 free index ETFs. However, keep in mind that ETFs are not as automated as robo-advisors. I would start with a robo-advisor account and then optimize and improve it later as you start to improve on investing skills.

Therefore, to reach Tier II, you must set up a retirement account and automatically contribute 10% of your income. Typically, I would steer clear of the company’s 401k plans, unless they offer a match. If they provide a match, then it’s free money and you can start Tier II by setting up your 401k, but only up to the amount the company will match. Why? Because 401k plans have a lot of hidden fees and are quite expensive to administer. Most of the people who get rich in 401k-land are the providers, not the participants.

Also, how do you know you are on your way to retirement? I would use these very general statements. You want “four figures” in your 20s so that one day in your 30s you can achieve “five figures.” And you’re doing it so you can get “six figures” sometime in your 40s. If you do, you’re looking to get to “seven figures” sometime in your 50s. And if you want additional credit, then you’ll get “eight figures” somewhere. time between 60 and 70. If you are 27 years old and have $ 4,000 in your retirement account, you are well on your way. If you are 38 years old and have $ 55,000 in your retirement account, you are generally on the right track. If you are 44 years old and have $ 145,000 in retirement, then you are well on your way.

The main point here is that you need to have a “four figure” portfolio before you have a “five figure” portfolio and so on. And that a retirement portfolio will use the power of compound interest and a long-term horizon to generate great returns. This is a very general rule that does not apply to everyone. Also, this does not allow someone to skip the “objectives” section of creating a risk and investment profile. It should be used as a very general rule of thumb. I’ll give another rule of thumb in later articles. For now, I hope this point has been helpful and enlightening for you on how to win at Level II of the financial freedom game – setting up a retirement account and investing process.

So, are you ready to complete Level II: Set up a retirement account and save 10 percent a year? You can do all of Tier II in one step: set up a Wealthfront account and set up an automatic monthly contribution to a traditional or Roth IRA. Or you can set up your 401k at your company, as long as they have a generous matching policy. Or, you can set up a TDAmeritrade account, set up an automatic monthly contribution, and invest using your free indexed ETFs. All of these approaches lead you down the path of investing for retirement. You can improve it later. The goal is to simply get started and then make management automatic.

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