Reduce retirement risk: Diversify investments
Part I: The benefits of setting up a income strategy
By Alan Klayman | Published: May 21, 2008
Dear Maturing Loans,
You keep saying not to rely on investments as part of retirement income, but to create an income strategy. What exactly is an income strategy, how does it work and why is it better to generate income from that instead of your typical investments? -- Samuel
Great question. An income strategy is a method or plan to turn your savings and investments into spendable cash with the goal not to run out of money. An investment is a vehicle that is purchased with the intent to increase in value over time, either through the payment of coupons, interest, dividends or an increase in the share price.
An error many people make is that they buy an investment thinking that it will make them a lot of money without any regard to the suitability of that investment relative to the rest of their situation. For example, a 90-year-old woman takes her last $10,000 and buys a technology stock. Can she make money from the stock? Yes, if the share price goes up. Can she lose money? Yes, if the share price goes down.
When we talk about suitability, we must ask the question: Is a one-stock portfolio advisable for this 90-year-old investor? To answer this, we need to look at what would happen if the stock goes up. If it goes up by 50 percent, which would be a lot, then she would have $15,000. Does having $15,000 make a big difference from having $10,000? Probably not. It is better to have more money than less money, but $5,000 doesn't go that far today. Again, it's better to have it than not have it. But what happens if the company goes out of business and the stock value is $0? Then our 90-year-old investor is broke. Not a very good scenario. In this case, the risk far outweighs the reward and the one-stock portfolio is an unsuitable investment for her situation.
Many people look at investments without evaluating what they need to sustain their incomes for the rest of their life. The 90-year-old example above is an extreme example, but the results are the same. If you do well, great. If you don't, you have no money to generate an income for the rest of your life.
The premise of investing is to buy at a lower price and sell at a higher price. This is not unlike investing in a home. If you don't want to sell your house at a lower price than at which you bought it, then why would you choose an income strategy that does that with your stocks, bonds and mutual funds? It doesn't make a lot of sense, but again, this is a common error. You actually find this strategy as the default in many retirement income calculators.
This is where choosing an income strategy that suits your situation comes in -- by establishing a systematic plan that uses instruments designed to give you income for a period of time (examples: three years, seven years, a lifetime) where you are not putting your income at risk. You then take your investment portfolio or purchase investments to make sure that you are providing an income over this specific period of time. In addition, you will want to take any remaining investments and grow money over time to cover inflation, cost of goods and many other reasons. This is the money you are attempting to grow and this is where you look at investment or growth strategies.
The income-producing money and the growth funds are separate. You cannot commingle this math. If you do, you are making a mistake that could cost you down the road.Ask a question.
Alan Klayman is creator of MyIncomeStrategy.com and CEO of Klayman Financial LLC. Klayman specializes in retirement income planning, business management and planning, estate planning, tax-advantaged investing, trust investment management, professional money management, insurance and annuities, mutual funds, fixed income securities, and institutional and personal retirement plan administration.
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