Retirement Planning for Business Owners: Understanding Investment Concepts

By QuickBooks

5 min read

Small business owners and their employees are busy people. Now, they are being asked to take on the added responsibility of managing their own retirement money. While this may seem intimidating, there are some straightforward and time-tested rules that can make this important task easier. Here are some key investment concepts that can help you earn and retain more money for your retirement.

Asset Allocation

Asset allocation is a critical investment decision. It not only helps you become wealthy, but helps you keep more of your money by reducing risk.

Allocations are often made by dedicating your money between stocks, bonds, commodities and real estate—including your house—based on your time frame, needs and risk tolerance. This is critically important because one expert predicted that no matter what single investment you pick, that investment will fall in price by 50% to 70% during your lifetime. The last two recessions in the 1990s, for instance, each caused a 50% stock market decline.

Since most people fear losses more than gains, they should divide their investments into those that are more secure, or which potentially deliver growth accompanied by higher risk. This includes stocks and bonds, but, surprisingly, not real estate. Home prices vary widely by region and are subject to price bubbles. They do have distinct tax advantages, however, and for some people can be a source of rental income.

Asset allocation should be viewed as a risk-growth proposition. The understanding is that no asset class (bonds vs. stocks, for example) appreciates continuously. Additionally, since markets run in cycles, it is possible to lose all gains without adjusting the portfolio.

Asset allocation is done by investing in as many as seven main asset classes across different markets internationally and in different time frames:

  • stocks, including exchange-traded portfolios, or ETFs
  • high yield bonds
  • real estate
  • commodities
  • currencies
  • structured notes

Many experts, such as John Bogle, the founder of Vanguard Funds, say the easiest way to diversify is by investing in low-cost index funds. These provide a tax advantage as well as broad equity exposure.

For a historical overview of how certain asset classes have performed, check out Novel Investor’s clickable chart of historic asset gains and losses.

Here’s an Example: Cut the Downside, Expand the Upside

Most investors don’t know this, but since equities are three times more risky than bonds, the returns in a 50%-50% balanced stock-bond portfolio will always see the equity portion fall more than its fixed income counterpart. Put another way, from a risk perspective, a 50%-50% stock-bond portfolio means that 95% of the portfolio’s risk is in stocks.

In real-world terms, the S&P 500 Index lost a total of 134% from 1973 to 2013. Alternately, the Barclays Aggregate Bond index suffered losses of just 6% during the same period. In this time frame, equities accounted for 95% of the losses. This gives a whole new meaning to the practice of balancing a portfolio, especially if investors want to contain their risk exposures.

The real-world of investing is also changing, and this change should be reflected in your asset allocation and risk management decisions. For instance, asset allocation is based on the idea that different asset classes, (stocks and bonds, including sub-classes of each) all rise and fall to different levels in any market cycle. This is called non-correlation.

But in the severe 2008 recession, all asset classes fell together. On the upside, some successful investment managers have noted that all asset classes will have periods when they are clearly more profitable than any other.

What drives the prices of all asset classes are inflation, deflation and declines or gains in overall economic growth. What makes this more challenging is that each of these economic conditions affects each asset class differently. For instance, in periods of rising economic growth, stocks, corporate bonds and commodities should gain more in value relative to Treasury bonds and inflation-linked bonds, which should fall in value. Inflation does the opposite. In an inflationary environment, commodities, gold and inflation-linked bonds should outperform stocks and Treasury bonds.

In terms of specific asset allocations, one successful hedge fund investor recommends exposures of 30% in stocks, 15% intermediate bonds, 40% long-term bonds, 7.5% gold and 7.5% in commodities. This portfolio is then re-balanced at least once a year. For an illustration of various exposures across an investment period, check out T. Rowe Price’s Investing by Time Horizon infographic.

Getting Defensive

The timing of losses in a portfolio is another element that determines portfolio returns.  For example, if a person suffers major losses early in his investing career or when he starts to retire, it can produce losses over time that cannot be recovered. Take the case of an investor who retires at 65 with a $500,000 portfolio and plans to withdraw 5% annually. But he then suffers consecutive annual losses of 10%, 13% and 23% during his first three years of retirement. Due to these losses, he will only be able to withdraw $580,963 from his original $500,000 portfolio.

Alternately, another investor with a $500,000 portfolio who plans to withdraw 5% annually and does not suffer any portfolio losses until she is age 71, will be able to withdraw $911,482, or 59% more than the man who suffered losses early in his withdrawal period.

A common defensive strategy is to use annuities to guarantee an income for life. There are various types of annuities:

  • immediate
  • deferred (fixed, indexed, hybrid)
  • variable
  • fixed deferred annuity

Fixed index annuities have become popular since they allow investors to control their deposits, often have a 100% principal guarantee and deliver guaranteed income for life when investors purchase an income rider. Another less-known product is private placement life insurance that allows buyers to make unlimited deposits and then shelters gains and money left to heirs so it can be distributed tax free.

The problem with annuities is that they often carry very large fees, some of which are hidden. Annuities are popular since they provide a predictable monthly payout, but investors can pay dearly for that peace-of-mind. Investors who are interested in annuities should hire an independent expert to review any annuity to decipher its benefits, the underwriter and costs. It’s a prudent small step that can save you thousands of dollars over your lifetime.

For more information, check out our articles on retirement options for entrepreneurs.

Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.

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